Kennan’s Warning on Ukraine
Ambition, Insecurity, and the Perils of Independence
Investors do not listen. Even amid the extreme market volatility of 2022, after the U.S. Federal Reserve had signaled that it would take a much more hawkish approach to fighting inflation, the financial markets continued to deny economic reality. Particularly in the United States, investors optimistically scanned U.S. Federal Reserve Chair Jerome Powell’s public remarks for signs that the economy had endured enough pain to bring inflation back down to the Fed’s two percent target. Over and over, they were disappointed.
On December 13, 2022, reports of cooling inflation were greeted with euphoria by the markets. But the very next day, amid volatile trading and falling stock prices, the Fed affirmed its commitment to tightening U.S. monetary policy and announced its unanimous vote to raise interest rates by half a percentage point. This increase was less aggressive than previous hikes, but markets nonetheless registered clear disappointment with Powell’s statement that higher interest rates would be necessary for some time and that additional increases were likely.
There was nothing surprising about Powell’s statement. What Wall Street traders seem not to understand about the Fed’s drive to defeat inflation can be gleaned from mountains of data from the markets themselves—specifically, the stock markets of emerging and developing economies. These markets have had to contend with past efforts to defeat inflation, and their performance over much of the second half of the twentieth century suggests what investors seem unwilling to hear: that more pain is on the horizon.
When drawing historical parallels to the current battle against inflation, analysts have most frequently looked to the actions taken by former Fed Chair Paul Volcker in response to the high inflation of the 1970s and early 1980s. To achieve disinflation, Volcker twice pushed the country into recession between 1979 and 1982, driving unemployment above ten percent before finally succeeding in bringing inflation down to the low single-digit levels that the United States enjoyed for almost the next 40 years. Today’s investors and market-watchers would prefer to dismiss this dismal parallel, hoping that this time around, things will be different.
But Volcker’s painful, protracted struggle against double-digit inflation was not unusual. In fact, it was the norm—part of a wider, recurring phenomenon, as nations across the developing world struggled to reduce inflation and enact other economic reforms to address the so-called Third World debt crisis. This crisis, which began in 1982, saw Mexico and more than a dozen other countries declare that they could no longer afford to service their debts. To tame inflation and get their economies back on track, they were forced to hike interest rates, trim their fiscal deficits, and implement certain reforms proposed by then U.S. Secretary of the Treasury James Baker at the 1985 International Monetary Fund and World Bank meetings.
It is tempting to dismiss developing countries’ economies as too dissimilar to the United States’ dollar-driven advanced economy to provide a useful comparison. Argentina, for instance, faced recurrent bouts of triple-digit inflation from the 1970s through the 1990s and is once again facing high inflation—94.8 percent in 2022. But most developing nations are not Argentina. In fact, there were more attempts to reduce moderate double-digit inflation—56 attempts spread across 16 developing countries between 1973 and 1994—than attempts to reduce high inflation. The median level of annual inflation during those episodes, 15 percent, was similar to peak inflation in the United Kingdom, the United States, and the European Union in 2022.
As Paul Samuelson joked, the “stock market has predicted 9 of the last 5 recessions.”
The current bouts of inflation in these three economies, and the earlier episodes of inflation in emerging markets, have parallel origins: large, spending-driven fiscal deficits. Further similarities include a context of foreign wars, oil-price spikes, and other shocks. Moreover, because the developing countries in question had publicly traded equity markets—another similarity to today’s advanced economies—the historical performance of their stock markets contains useful hints about what the future may hold for the United States. The 56 attempts to reduce moderate inflation in developing countries between 1973 and 1994 say more about the current economic moment than the single Volcker disinflation episode.
Disinflation policies bring the short-run pain of rising interest rates and falling earnings that economies must endure to reap the long-run gains that come from low inflation. Unlike lagging indicators such as growth and unemployment—both of which may suffer greatly in the short run as a result of policies to reduce inflation but can be measured only after the fact—the stock market is forward looking, a leading indicator of the future. If the expected long-run benefits of low inflation to publicly traded corporations outweigh the short-run costs of disinflation policies, then investors should drive up the value of a country’s aggregate share-price index when government officials announce the start of a credible disinflation program.
But that is not what happened in developing countries. Although the benefits to corporations of low inflation are substantial, bringing a more stable planning environment with attendant productivity gains and more predictable earnings, developing countries’ stock markets did not respond positively to announcements of disinflation programs. To the contrary, they reacted with an average cumulative return across the 56 programs of negative 24 percent, indicating that greater economic pain was necessary to reduce double-digit inflation to the single digits.
Given the recent volatility in U.S. financial markets, changes in stock prices might not seem like the most reliable indicator of the broader economy. As the MIT economist Paul Samuelson joked, the “stock market has predicted 9 of the last 5 recessions.” But even Robert Shiller, who won a Nobel Prize for his skepticism of the informational content of stock prices, has argued that “some substantial fraction of the volatility in financial markets is probably justified by news about future dividends or earnings.” The announcement of a credible disinflation program would certainly contain such news and lead to a market reaction.
If the expected benefit to corporations of reducing moderate inflation does not in fact outweigh the cost of doing so, as the historical performance of emerging-market stock indexes suggests, then why even try? There are two answers to this question.
First, the alternative is worse. Data from emerging economies demonstrates that moderate inflation typically does not stay moderate, but tends to rise, becoming increasingly disruptive to productive economic activity and eroding the purchasing power of ordinary people.
The second reason is that, important as it is, the stock market is not the economy. The history of disinflation-induced drops in emerging-market equity prices shows that sometimes the market has to pay the cost of getting society to a better place. There is no low-cost way of going from moderate inflation, where the United States started in July 2022, to low inflation. U.S. markets have been ignoring a simple reality: there is no painless way to restore price stability. Volcker knew this. Powell knows it, too. In response to the suggestion that the Fed could raise its target for inflation above two percent, he stood firm. “We’re not going to consider that under any circumstances,” he said in December. “It will take substantially more evidence to have confidence that inflation is on a sustained downward path.”
Reducing inflation to low, stable, and predictable levels is absolutely necessary for countries to achieve sustainable long-run growth.
The journey from moderate to low inflation can take years, as Chile’s experience shows. Following a decade of little progress toward achieving stable prices, in September 1990—with annual inflation in excess of 20 percent—the country’s central bank announced that it would adopt an official target for annual inflation and tighten monetary policy as necessary to achieve it. The first target, set for the period of December 1990 to December 1991, was 15 to 20 percent, with the central bank reducing the annual target by 1.5 percentage points each year from 1991 to 2001. By publicly articulating an explicit goal and putting its credibility at stake, Chile’s central bank was able to reduce inflation to 8.2 percent by 1995 and keep it in the single digits through 2021.
In the broader developing world, despite the drops in stock market valuations following the announcement of disinflation programs, countries that had the discipline to stay the course saw significant improvement in their long-run economic performance. In the ten years following these countries’ successful transition from moderate to low inflation, their average annual growth rate was almost 1.5 percent higher than in the previous ten-year period.
Countries that capitalized on their new low-inflation environment to implement additional reforms experienced an even more rapid economic turnaround. For example, nations that opened up their economies to free trade (many of which were in Africa) saw their ten-year average annual growth rate accelerate from 1.72 percent to 4.38 percent—an increase so large as to more than halve the time it takes to double the typical citizen’s standard of living.
It is hard to argue with this kind of growth—growth that in the aftermath of the 2007–8 global financial crisis powered the world’s economy. Despite the short-run pain of recession and unemployment, reducing inflation to low, stable, and predictable levels is absolutely necessary for countries to achieve sustainable long-run growth. There are no counterexamples.
U.S. inflation numbers are moving in the right direction, but they remain above the two percent target that the Fed must hit to restore price stability and maintain its credibility. Even though further rate increases could mean additional U.S. market drops, Federal Reserve officials would do well to remember the lessons of the past when they convene in February. And once the Fed finally hits its target, U.S. lawmakers must then implement the economic policies required to boost productivity and make the most of renewed price stability.