1946! Interest rates, inflation, and war

I'm not a trader, and I don't put much faith in short term charts the likes of which you typically see in financial porn. Longer term charts, however, are more interesting. It is much easier to separate the signal (or trend) from the noise, and the "trend" is a reflection of the economic psychology of the public. Not just that part of the public that invests, but the public who buys houses and has mortgages, buys cars and retail and pays on credit, or even saves in CDs and money market accounts. In short, just about everybody.
There is in fact one such very long term cycle as to which there is compelling evidence: the Kondratieff cycle of ~ 60 years. A graph of the Kondratieff cycle shows interest rates alternately declining or increasing for lengthy periods of time of about 30 years each, for a total cycle, peak to peak or trough to trough, of about ~60 years. I subscribe to a belief in the Kondratieff cycle for a very simple reason: it is amply supported by obvious evidence that can be easily shown in a graph.
For example, here is a graph that includes among other things interest rates (shown in red) from 1880 to 2000 -- a period of 120 years:

Notice that there are long term peaks in interest rates in 1920 and then again in 1981 -- 61 years later. There are long term lows in interest rates in 1899 and then again in 1946, 47 years later. Keep this 1946 low in interest rates in mind -- and indeed the fact that interest rates throughout the entire decade of the 1940s were under 3%. We'll come back to that.

Many commentators (like the one linked to in the intro to this diary) divide the Kondratieff cycle into seasons: spring (non-inflationary growth), summer (inflationary growth), autumn (growth with disinflation, i.e., declining inflation), and winter (a deflationary depression). I think those distinctions get too artificial and restrictive, but there is simply no getting around that interest rates follow very long term cycles.

All very well and good, you may say, there was a 61 year period from 1920-81 of highs in interest rates. But has that been the case before and what about now? I'll spare you the noisy charts that go back to the 1600s, but the last interest rate peak before 1920 did indeed occur in ~1860, exactly 60 years before. You can see some of the decline from that high on the red line in the chart above. And as for the present, here is a chart of long term interest rates (the 10 and 30 year treasury bonds) from 1981 to the present, 27 years later:

Lo and behold, there has been a decline in interest rates that potentially is intact to this day, a period of 27 years. I say "potentially" because the lowest long term rate since before 1970 was set by the 10 year bond in 2003. That rate was ~3.10%. (Right now the 10 year treasury yields ~3.70%).

Why does the Kondratieff curve have validity? Because long term economic activity is based on human psychology, and that in term is based on memory and experience. Which means that it is limited by the adult human lifespan. Now, even in the old days there were a few old folks around how might be counselors and elders to younger rulers, and who had living memory of the last inflationary/deflationary big event, but at some point after about 60 years of adult life, they are all gone. And once they are gone, there is no liviing memory of the last big turning point -- and so the living generations must learn the lesson again.

For example, even now Boomers and survivors of the Silent and Greatest generations before them remember the tremendous inflation of the 1970s and don't want to see it happen again. But how many financial or economic advisors have any living memory of the Great Depression? With the disappearance of that event from liviing memory, society is far more likely to replicate the conditions for a similar occurrence.

Now that we have discussed interest rates, let's revisit inflation. Why? Remember how I told you at the outset to keep in mind how the above 1st graph showed that interest rates were under 3% in the 1940s, and hit a long term low in 1946? Something interesting happened with inflation at that time: there was a brief but large inflationary impulse. Here's a chart of the consumer price index (CPI) for the 1940s:

Unfortunately I can't show you the inflation rate and interest rates together, because the Federal Reserve charts don't track interest rates back that far. What I can show you is the CPI from 1921-1980 (in red), and interest rates beginning in 1962 (in blue):

But you can see that, at the very nadir of interest rates for the entire 1920-1981 cycle, inflation very briefly took off, in 1946, an inflation that had dramatic political effects:

The paramount postwar American economic problem faced by Truman was inflation, not depression as many had projected. The tasks of restraining consumer spending while convincing labor to hold off on wage demands and businesses to hold down price increases became insurmountable for the new and inexperienced president. A series of strikes in 1946, threatened to push the American economy into an inflationary spiral. .... [B]y late 1946, after pressure from nearly all sides of the economy, [price] controls were finally lifted except for those on rents, sugar and rice.

In November 1946, the Democrats suffered a severe defeat in the congressional elections. The result was the 80th Congress, the first Republican-controlled Congress in 16 years. Bent on dismantling the New Deal, the 80th Congress moved to limit the power of labor, lower taxes, and ride their successes on to victory in the 1948 presidential election.

In fact, the 1946 inflation rate of ~20% was very highest yearly inflation rate of the entire 1920-1981 period. Inflation had not exceeded interest rates since the onset of the Great Depression, but did take off during and after World War 2; and did not do so again during the entirety of the 1950s, 1960s, or the early 1970s. Only near the very peak interest rates of ~1981, as well as near the very trough of ~1946 did the inflation rate meet or exceed rates on long term interest.

Now let's look at the current cycle. In the chart below, interest rates are the blue line, and the CPI is the red line:

You can clearly see that after Fed Chairman Paul Volker choked off inflation by causing the worst recession since the 1930s, in 1981-2, it has remained under 5% a year for almost the entire 25 years since. But notice that here we are, almost certainly at or near the trough in this 1946-2003? (low to low) or 1981 - 2040? (peak to peak) Kondratieff cycle, and again the inflation rate (currently at 4.3%) exceeds long term rates, at least as measured by the 10 year bond.

Imagine what a 1947-style 20% inflationary spike would do now, with wage growth for the median American stuck at about 3% a year, and interest rates on CDs and bonds in the 4% range? Given what is happening to the dollar, to the price of oil and foodstuffs, and the inflationary impact of the Iraq war in particular, another inflationary burst marking the exact midpoint in the interest rate cycle cannot be discounted.

Meta: 

Comments

Being There

Good God, this reminds me of Chauncey, Peter Sellers character in Being There.
With the falling dollar, our twin deficits and this idea of just increasing credit, money supply by the Federal Reserve, I see inflation coming. (But does this indicate you've changed your mind from your previous post?)

But your link claiming economic depressions and simply "self-healing" I think to myself, hey, I of course do not remember the great depression personally, but I do study history and love documentaries, especially on the great depression and I cannot describe such a period as self-healing and think it better to drastically alter policy on a variety of fronts to avoid such an event versus look at it all as Chauncey's Garden

Kondratieff being executed for simply doing economic research is quite a horrific story in and of itself!

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Theroxylandr in flame?

I think that's the link you're referring to. He does a great job explaining the Kondratieff "seasons" but I don't subscribe to anybody else's political gloss on them.

I still believe we are very close to the highest inflation rate we will see this year, which will decrease during and after the recession we are in. But I foresee the economy having a respite towards the end of this year, and at some point after that inflation will resume.

Alternatively, it's certainly possible that we already had the biggest inflationary burst by way of the housing bubble, as suggested by this graph from Tim Iacono of The Mess That Greenspan Made:

This diary can best be described as me thinking aloud, taking into account the odd confluence of low interest rates and high inflation that occurred exactly at the trough of the last K-wave, and considering the significant possibility that in our imminent past or future the situation will recur (but this time without the post WW2 wage pressures).

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I'm agnostic

I'm just reading and certainly agree that most people have not even lived with 1981 to remember.

Ya know we need more people on here who can understand what you are saying. I think that's why you are getting readers but not to many comments.

(to all of you chickens out there, stop lurking and post a comment, do you believe inflation will peak or will continue to increase?)

That would make a nice poll actually.

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1946! Interest rates,

Increase or peak? I have no idea, peak would be a guess.

What I do know it that my grandfather lived through the 1930s depression. In 1933 he took a job with the railroad and his family was ok after that. But he never, never, ever kept any money in a bank after 1929.

I saw him pull out a wad of bills and pay cash for a 1957 Chevrolet. He died with money saved in his sock drawer. Remember his longstanding fear of banks, I have recently moved a sum home for emergencies because I think our economy is completely hollow we are in such debt -- not me prsonally, the country. Since the 1980 I believe the value has been harvested (merged and stripped, off-shored, etc.) and all that is left is hollow debt.

My mother's second husband was a boy during that depression. His family survived by eating a lot of apples. When he died in 2000, he still hated eating apples because of the memories of having only apples to eat.

An asside: No one in my family ever did use debt except for their mortgage. They believed in paying cash. But now few people hesitate to buy something that they don't have the cash for. Most people's budget problems would dissappear if they only used cash.)

That depression must have been horrible on people and it certainly left long lasting effects on anyone I knew who lived through it. But I feel influenced by it even these generations away, because of my family's stories.

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