Policy, Uncertainty and a New BookAugust 5, 2014
When Cumberland Advisors was formed in June 1973, the early stages of the Arab-Israeli War, oil price shock and subsequent turmoil in the Middle East were well underway. Egyptian President Gamal Abdel Nasser’s closing of the Straits of Tiran (aka the Suez Canal) back in 1967, blocking Israeli access, had contributed to rising tensions between Egypt and Israel that ultimately led to an attack on Israel by Egypt, Syria and some elements from Lebanon on Yom Kippur in 1973.
If there was ever a mistake made by military strategists, it was the decision to attack Israel on the holiest holiday in the Jewish calendar. The strategists on the attacking side reasoned that there would be the maximum amount of vulnerability among the population in Israel at the time as the nation, including its military, observed the Jewish Day of Atonement. They did not realize that the attack was taking place on the one day during which stores were closed, shops were sealed, highways were somewhat vacated and the assemblage of people enabled the citizen army of Israel to quickly mobilize in defense of the country. Had invading forces attacked on some other day, the outcome might have been somewhat different.
History shows that military turmoil by itself does not create negative stock market environments. History also shows that confrontations and military turmoil raise risk. The risk evidences itself in the subsequent outcome.
In the case of 1973-1974 war in the Middle East and the quadrupling of the oil price, the shock of the price hike plunged the US economy and the rest of the then-advanced world into a state of recession. Faced with an energy-induced price shock that was raising prices and triggering an inflationary response, Arthur Burns, chairman of the Federal Reserve, responded. At one point Burns took interest rates in the US to what was, at that time, their highest level since the Civil War. Nobody knew then that interest rates would subsequently go much higher due to Paul Volcker’s successful attempt to stop the inflation rate from rising into the double digits.
I recall all of this vividly. In the early years of Cumberland Advisors’ history, we were dealing, as we are now, with a sequence of unfolding events with uncertain outcomes. And history could not adequately guide us.
One possibly major factor to contemplate about the 1970s and the energy-induced inflation shock is the transmission mechanism that occurred in response. Burns tried to deal with recession and inflation at the same time. He set a policy course that was somewhere in the middle and therefore unsuccessful on both fronts. Monetary policy works best when it implements a positive real interest rate and ignores an exogenous price shock. Monetary policy waits until the shock subsides, substitution effects occur, and the price level restores its rate of change to a basic trend.
That is what we were taught when we studied monetary economics in school and what we learned afterwards in the period since WWII. A lot of uncertainty and controversy results when the system is structured in reverse. We are navigating now an era of expansive monetary policy. In the US, the Federal Reserve has added over $3 trillion to the size of its balance sheet by creating that money and acquiring federally backed securities.
The combined balance sheet of the major central banks of the world (Bank of England, European Central Bank, Bank of Japan and US Federal Reserve) has tripled in size since the financial crisis six years ago. At the same time, the inflation rate remains very low. Now we are seeing turmoil in the oil-producing sectors of the world, in places like the Middle East, Nigeria and Eastern Europe where the Russian Federation’s influence dominates.
Can the transmission mechanism of an oil price shock once again result in inflation, as we saw in the 1970s? During that decade, the energy price shock came first, followed by an expansive monetary policy that validated rising prices and permitted inflation to take hold. A fundamental question now is whether that sequence is important. Our view at Cumberland Advisors is that we do not know. We have a historical precedent in which the sequence was price shock first and monetary easing next. This time around, we have monetary easing first and price shock next.
Will we see the same result – inflation – regardless of the sequence of those two events? It seems to us that the answer is maybe. We are going to find out. Risks are higher because of this uncertainty, which will segue to clarity only with time. That is one of the reasons we are maintaining cash reserves.
The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.
The preceding is an abridged commentary by Cumberland Advisors and has been reposted with permission of the author. Cumberland Advisors commentaries are available at http://www.cumber.com/commentary_archive.aspx.
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