Is the U.S. economy in for a hard, soft, or somewhere-in-between landing from the monetary tightening cycle? As someone who has been both on the academic and business side of finance, and has deep experience with managing risk, Myron Scholes is qualified to address the question.
Scholes won the Nobel Prize in 1997 along with Robert Merton for his work on the Black-Scholes option pricing model — a formula for the valuation of stock options and other derivatives. He was also part of a group at the University of Chicago, led by Eugene Fama, that advanced modern portfolio theory and the efficient market hypothesis.
So, what does Myron Scholes think of the Federal Reserve’s battle to reduce inflation?
As a result of the COVID crisis and the situation in Ukraine, the Fed and other central banks will have a tough time reducing inflation even as they aggressively raise interest rates, Scholes said on a webcast hosted by Janus Henderson Investors (Scholes is the asset management firm’s chief investment strategist).
“In my view, the real rate [of interest] is the issue,” Scholes said on the Wednesday webcast. “The real rate [of interest] is still negative, it’s too low, and the Fed will have to increase rates until such time as the real rate becomes positive, creating an opportunity for us to grow again.”
But to do that will require “quite a long time” Scholes said, referencing the experience of Paul Volcker’s Fed in 1980, when the central bank lowered the Fed funds rate to 8.5% in June only to have inflation return, forcing Volcker to increase the Fed funds rate to 20% again in December.
“I hope it’s a soft landing, but I fear that there are much greater odds that we’re going to have a harder landing or deeper recession, because of the need for the Fed to keep going,” Scholes said.
Two big problems confront the U.S economy, Scholes said: labor market strength and commodity prices affected by COVID-19 and the Russia-Ukrainian war.
“Scarcity and wage growth are still headwinds that have to be addressed by the Fed,” he said. “The Fed’s not slowing down, they read history. … And they’re also fighting against a government that’s deficit financing and putting more money into the economy.”
The silver lining is that this inflationary period creates an opportunity for change, Scholes said. “Because if you think everything’s working, there’s little incentive for change. But shocks create an opportunity to change, and the change creates forces that move [us] forward.”
Indeed, in the 1970s, when Scholes was researching stock options, financial markets experienced some rapid-fire changes in products, investing, and financing methods. ‘The economy was let loose in the inflation of the ‘70s,” he said; “it changed a lot of the dynamics.”
Starting in 1973, when his famous paper co-authored by Fischer Black, “The Pricing of Options and Corporate Liabilities,” Scholes witnessed the creation of currency, interest-rate, and stock index futures, the birth of the Chicago Board Options Exchange, the development of the swaps and mortgage-backed securities markets, and the growth of hedge funds, to name a few innovations.
He also lived through the bad, of course — Black Monday, the October 19, 1987, stock market crash, whose 35th anniversary was Wednesday. And on a more personal level, in 1998 the failure of Long Term Capital Management, a highly leveraged hedge fund he co-founded that attempted to put some of modern portfolio theory into practice.
Scholes believes finance will be no less innovative in the next 35 years. Solutions will be developed that will help companies and investors execute finance functions “faster and more individualized, and with more flexibility,” he said.
How we marry together teams and capital will change in the future. — Myron Scholes
The innovations, enabled by technology and vast amounts of data, will create ways of building trust in the transaction and processing world, he said. Finance will move from a world of transaction processing and clearing trades, to “transaction analyzing, serving the individual through and using [the large amounts of data available] to help them with their needs and wants.”
That will reduce the role of intermediaries in many financial market functions, he said. But the more data firms have, the more they can develop individual solutions, according to Scholes. That will result in the financing of smaller and smaller projects. “How we marry together teams and capital will change in the future,” he said. Teams will be allowed to “access capital more dynamically and more flexibly and easier than in the past.”
What Scholes has learned over the years, he said, is that innovation is about trying to limit, eliminate, or mitigate the power of constraints, which is where the profit opportunity is. “Anything we can do to make provision of services faster, more individualized, and more flexible under uncertainty are really the growth areas,” he said.
And what about the unintended consequences of some innovations, like subprime mortgages and collateralized debt obligations?
We’ve had failures in the past because innovation got too far ahead of infrastructure, Scholes said. “But you have to have innovation first, and then infrastructure follows. … We can’t have enough infrastructure to support all innovation or no innovation would occur, because it’s just too expensive to build all the infrastructure.”
Failure in innovation, Scholes said, comes about from not considering tail risk.
“You can educate students about Black Monday and other tail events and make them aware of the tails of distribution, but unless you live it you don’t remember it,” he said.
“And one of the interesting things about the people who lived through Black Monday or have experienced tail events is that they disappear. The experience tends to be lost.”