What we can learn from history
With a shaky 2022 behind us, investors are looking ahead and asking themselves: what will the stock market year 2023 be like?
Inflation peaked at just over 9% in the US last summer and has since fallen back to 6.5% in December. As the pace of consumer price rises falls, the Federal Reserve has also slowed the rate at which it raises interest rates in its attempt to combat inflation.
If there's one thing investors have learned in recent years, it's that economic prospects matter little compared to the Fed's actions, and now the question is - with falling inflation and a potential recession and even temporary deflation around the corner - how will the Federal Reserve act and what will that mean for the stock market?
One calamity rarely comes alone and, so too, do inflationary peaks. Since the inception of the Federal Reserve, there has not been a single time that the inflation rate has risen above 5% and then fallen back to the inflation target without the US Consumer Price Index CPI picking up speed again before inflation returns to normal.
What World War I, World War II, the 1970s and what is happening today have in common is that the money supply was expanded before each inflation event.
During World War I, the United States exported large quantities of raw materials and other products to Europe, which also caused the US gold stock to rise by almost 80% in a short period of time. Since the Federal Reserve had been founded only a few years earlier, there was no way to handle the large influx of gold and thus the expanded money supply, which eventually led to inflation rising to over 20 percent in 1917. It would take until 1920 for inflation to fall, with the CPI going from +23.9 percent YoY to -15 percent in just one year.
The same pattern can be found even after the First World War and until the end of the Second. Even then, the rate of inflation was strongly related to the US gold stock. Thus, more money available has also historically led to higher consumer prices and vice versa.
Even in the 1970s, when the US last experienced high inflation for an extended period, it was initially due to the US completely leaving the gold standard, which led to the devaluation of the US dollar against gold.
Besides the fact that all historical inflation events have increased money supply in common, the Federal Reserve's response to rising inflation and the recession that follows has looked frighteningly similar every time.
Unlike investors and economists who often try to create a picture of what the future will look like and prepare their portfolios for it, central bankers work differently. Instead of trying to predict the future, central bankers instead act on historical data. Will the CPI come in low? Then we accelerate. Is inflation high? Then we put the brakes on. Does the CPI fall temporarily into deflationary territory because of a recession created by high inflation? Let's print money until we're out of the crisis.
This is also the action that leads to boom-bust cycles. Without an expanded money supply, consumer prices could not have risen as much. Without a sudden and sharp slowdown, prices would not have fallen as fast later.
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