Inflation: Transient or Persistent, Lessons from the 1970s
I wrote an article about the basics of inflation in my blog on February 3rd (“Inflation”) which provides a good foundation for understanding the mechanics of inflation. As a follow-up, I wanted to look at two historical periods in the US as context for determining what might be in store next for the US economy, following the deployment of an unprecedented amount of unconventional monetary stimulus (and fiscal stimulus) to restore the economy to growth. Of course, questions about unconventional monetary policy and its inflationary effects also exist in other countries, including the UK and the EU, that have also unleashed massive amounts of unconventional monetary stimulus. This article will focus on the sustained period of high inflation in the US in the 1970s-early 1980s, and the next one will look at the period following the Great Recession (2008-2019).
Inflation is already increasing in many places around the world, “manufactured” by the Federal Reserve and other central banks in developed countries to more quickly propel economies out of their pandemic-induced slowdown. The Federal Reserve, ECB and the BoE have all been crystal clear that their objective over time is to achieve an average inflation rate of 2%/annum. More importantly, these central banks are prepared to let inflation increase above the 2%/annum average target because they believe such inflation is transitory and will promote higher employment more quickly. The debate playing out amongst both economists and investors is whether or not such above-average inflation will be temporary (as the Federal Reserve expects) or persistent. Persistent inflation means that inflationary expectations become baked into the economy, creating a spiral that becomes more and more difficult for central banks to proactively address.
I believe that inflation in the US will be transitory not persistent. In the Eurozone, I think persistent inflation is even less likely since the structural nuances of the currency bloc have caused the Eurozone to struggle for years even to get to 2%/annum inflation, much less consistently higher. Rather than inflation becoming embedded, my fear is that the Federal Reserve will mis-manage the unwind of monetary stimulus when it pivots to curb inflation. The Fed might err as far as the timing of its pivot, or in terms of the sequence of policy actions it unleashes to temper inflation, or it could err on both. The right cocktail of policy steps and the timing / sequencing of such steps are as much an art as a science.
Central banks clearly have the policy tools to address higher-than-expected inflation. Amongst the many policy tools at their disposal, central banks could raise the discount rate, or they could reduce purchases of securities under their quantitative easing programmes (referred to as “tapering”), or they could do (and will likely do) both. If these steps are not well advertised in advance and executed with precision, financial markets might be rattled, and the collateral damage would feed into sentiment and tip the economy into recession. The stakes are even higher because many asset classes, like equities and real estate, are highly inflated, approaching “bubble territory” according to many pundits. In fact, there are enough similarities in the lead up to the highly inflationary 1970s and today in the US that it is worth examining them, recognising of course that there are also plenty of differences between each period.
In April, inflation was 4.1% in the US, a level that initially surprised economists and shocked investors since CPI was significantly above expectations. Higher-than-expected CPI also elevated questions around exactly what rate of inflation is “too high” during this economic recovery phase. I agree with Chairman Powell that inflation is likely to moderate as the coming months pass, which are expected to be the fastest-growth period of the US economy. Once we get to the mid-to late-summer, I believe that CPI will be in the 3.5%/annum to 4%/annum range, triggering a policy response by the Federal Reserve before year-end. Furthermore, I would expect the Federal Reserve to telegraph its intentions for policy action by late summer for implementation beginning in the autumn. In fact, the Federal Reserve already seems to be ever-so slowly drifting away from Chairman Powell’s comments over the last few months that “the Fed is not even thinking about thinking about raising rates”. Although reaching full employment remains the central bank’s clear priority, the most recent FOMC Implementation Note (released April 28th, see full statement here) stated: “The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee's goals”, which suggests to me that the Fed is most certainly now thinking about next steps. Inflation averaging 3.5%-4%/annum for a few months once we’re past mid-summer is not a troubling figure to me. This sort of level is far from the highest level of inflation reached during the late 1970s/early 1980s, and certainly is a long ways from hyperinflation, a word I occasionally hear mentioned from time to time today. By now, central banks should be familiar with monetary history and know what steps to take to guide the economy back to 2%/annum average inflation, although I fully acknowledge that this does not necessarily mean the appropriate measures will be taken.
Let’s look back to the 1970s/early 1980s in the US, the last period of persistent inflation, and the factors that led to this situation. In fact, we need to go further back, because the foundation for persistent inflation began to be laid in the 1960s. US CPI fluctuated between 5% and 6% for the better part of two years starting in early 1969. Inflation went through ebbs and flows throughout the early years of the 1970s but rose again above 5% in April 1973. Inflation did not fall below 5% again (except for one month) until September 1982, nearly 10 years later. You can see in the graph below how inflation started to accelerate in the mid-1960s and was not eradicated until the early 1980s.
During this period, inflation reached twin peaks in November 1974 (11.6%) and March 1980 (13.7%), although the entire decade was characterised by bouts of high inflation and generally rising prices. This was not hyperinflation by any means, but clearly, persistent inflation had become embedded in the US economy, affecting peoples’ mindsets and making a solution more and more painful as time passed. The Federal Reserve was complacent, even accommodative, for much of the early and mid 1970s, until it acknowledged the problem and began to raise the overnight borrowing rate for banks (the Discount Rate) in mid-1977. When the Paul Volker became Chairman of the Federal Reserve in August 1979, he continued to tighten monetary policy, eventually overseeing an increase in the discount rate to 14% by June 1981. This served the purpose of bringing down inflation, but it came at a severe economic cost. The US experienced a double-dip recession in the early 1980s, falling into recession in 2Q1980 and again in 4Q1981. In July 1980, US unemployment reached 7.8%, and in November 1982, unemployment reached 10.8%, a level not breached again for nearly 50 years.
The factors that led to persistently higher inflation in the 1970s included a series of mis-steps mainly by the federal government, although the Federal Reserve was complicit too. Some of the factors that led to this dilemma were:
The Johnson Administration of the 1960s had spent vast sums on the Vietnam War and the “Great Society” simultaneously. President Nixon (Republican) took the White House from the Democrats on the conservative platform of cutting federal spending, but he inherited a recession when he took office in early 1969. He quickly abandoned his tight fiscal approach and sought to spend to ease the US out of recession and lower unemployment, carrying on the exceptional social spending of the Johnson Administration. The graph below from FRED illustrates the increase in federal spending since 1960.
Federal spending, which increased on average 6.4%/annum in the 1960-1965 period, averaged more than 10%/annum from the mid-1960s through the end of the 1980s. The highest annual increases during this period were in 1966 (+15.5%), 1974 (18.1%) and 1979 (+15.0%). Loose fiscal policy worked as far as stimulating economic growth and lowering unemployment, but it also released the animal spirits in terms of inflation. Still, public debt-to-GDP during the 1970s remained at a respectable 31%-34%, a far cry from level of the 4Q2020 (pandemic-influenced), which was 129%. Loose fiscal policy unquestionably added fuel to the inflationary fire during the 1970s and was an example of demand-pull inflation.
In August 1971, President Nixon imposed wage and price controls for 90-dayes to curb inflation, which had reached nearly 6% by 1970. Naturally, these controls eventually led to severe imbalances and shortages. When they ended, pent-up price pressures emerged. As stated by the Cato Institute (here), “A tight lid on a boiling tea pot can only contain the steam for a time before it explodes.”
Concurrently with announcing controls on wages and prices, President Nixon ended the convertibility of US Dollars into gold at $35/ounce in August 1971. This effectively devalued the US Dollar, pushing up the cost of imports, a form of cost-push inflation.
There were two oil shocks in the 1970s. An oil embargo by OPEC in 1973-1974 caused world oil prices to quadruple in a short period of time (from $3/bbl to $12/bbl). A second oil crisis occurred at the end of the decade caused by the Iranian Revolution followed by the Iran-Iraq war, causing oil to increase to $32/bbl. Broadly speaking, these were supply shocks, leading to cost-push inflation.
Throughout the period, the Federal Reserve vacillated on its interest rate approach, first decreasing the discount rate in the early 1970s to address slow growth, then raising the discount rate in 1973-74, then again gradually lowering the discount rate, before finally beginning the necessary tightening needed to curtail inflation. The discount rate increased from 5.25% in 2Q1977 to 14% by 3Q1981, which did the trick but at a severe cost.
As far as money supply, M1 increased an average of 3.9%/annum in the 1960s, increasing to 6.5% during the 1970s. M1 grew even faster in the 1980s (7.6%/annum), before reverting to more normal levels in the 1990s and 2000s. During this period – and in fact until the Great Recession – unconventional monetary policy in the form of QE was not in the arsenal of the Federal Reserve.
These unfortunate set of circumstances led to persistently high inflation that had to be addressed, causing this dire economic data to come to pass.
CPI peaked at 13.7% (March 1980).
Unemployment peaked at 9% (May 1975) and then 10.8% (Nov 1982) during the height of the second of two back-to-back recessions, with that high level of unemployment not being reached again until April 2020 during the early stages of the pandemic.
Capacity utilisation fell to 74.2% (May 1975) and then to 70.9% (Dec 1982), a level not breached again until June 2009 during the Great Recession.
The yields on the 2-year and 10-year US Treasuries (constant maturities) were above 10% between September 1979 through the end of 1982. The 2-year yield peaked at 16.95% and the 10-year peaked at 15.85% in Sept 1981. Note too that the yield curve was inverted from mid-1978 until the end of 1982. Here’s the trajectory of 2- and 10-year yields since 1962 (source: FRED).
What might really matter to you is how financial assets performed during this period of the 1970s, when the foot of both the federal government and the Federal Reserve were firmly on the accelerator, at least during much of the decade.
Equities: The 1970s was a poor decade for equities, with the S&P 500 index returning on average 2.2%/annum over this period. Concurrently, inflation averaged 6.8%/annum, meaning that the real return on equities averaged -4.6%/annum over the decade.
US Treasuries: The 10-year US Treasury, which started the decade yielding 7.79%, closed the decade yielding 10.62%, with the worse yet to come. The yield on the UST 10-year peaked at 15.85% in September 1981, before beginning to work its way back down. You can see the cost of taming embedded inflation was severe in terms of the cost in the bond market, leading eventually to high unemployment and a double dip recession in the early 1980s.
Gold: As far as gold, often considered an inflationary hedge, the price increased from $36.50/ounce at the beginning of 1970 to $455.92/ounce by the end of 1979. In October 1980, gold reached its highest price during this inflationary period of $660/ounce, before retreating. Gold did not reach that price level again for nearly 27 years. Remember that early in this inflationary period (August 1971), President Nixon ended the convertibility of gold at $35.00/ounce, moving the US Dollar to a pure fiat system.
The circumstances today are very different than those that characterised the late 1960s in the lead-in to the high inflation decade of the 1970s / early 1980s. Comparatively speaking, today we have:
Unemployment: High (6.1% April 2021), but well off the early-pandemic peak. In contrast, having reached 5.1% in Feb 1965, unemployment fell steadily to reach 3.5% by the end of the 1960s.
CPI: The most recent data (April 2021) had CPI at 4.2% but recall this is rolling out of the pandemic. CPI increased from 1.1% in Jan 1965 to a decade high of 5.8% in Nov 1969.
Capacity utilisation: Having bottomed at 65% in May 2020, capacity utilisation has improved to nearly 75% now. Capacity utilisation in the 1965-1969 period was significantly higher, running between 85% and 89%, illustrating an economy that was clearly running hot by then.
GDP growth: Real GDP growth averaged 5%/annum from 1965-1969. The most recent US data had 1Q2021 GDP growth at 6.4%, and consensus FY2021 GDP growth seems to be in the 6.5% to 8.0% range.
Interest rates: Interest rates are much lower today, both the overnight borrowing rate that is set by the Federal Reserve and US Treasury yields across the curve.
Monetary policy: During both periods monetary policy was arguably dovish, although the magnitude today is substantially greater. QE has been used by the Federal Reserve on and off since the Great Recession, with the balance sheet of the Fed now standing at $7.9 trillion, up from $4.2 trillion at the end of 2019 prior to the pandemic. Based on data from FRED back to 2002, the Federal Reserve balance sheet was less than $1 trillion prior to the Great Recession.
Fiscal policy: Both the late 1960s period and the run-up to the pandemic were characterised by accommodative fiscal policy. To see off the pandemic, the US government has unleashed massive amounts of additional aid into the economy, far more than was unleashed in the second half of the 1960s.
The graph below depicts more recent inflation data since the Great Recession, including the last data entry showing the spike up in April 2021:
The light blue line shows average CPI since 2009 – 1.6%/annum.
I do not fear persistent inflation, but I do fear how it will be contained and brought back to the average target of 2%/annum. Once the Federal Reserve becomes more hawkish to see off inflation, financial “risk” assets are unlikely to perform well. I read somewhere the other day (can’t recall where) that the performance of bonds and stocks might be positively correlated during the “adjustment period”, a relationship that is normally inverse. I can see this happening, as government bonds sell off as rate fears increase, and stocks concurrently sell off in anticipation of the Fed over-reacting and slowing the economy too abruptly. As an investor, it boils down to timing, but mis-steps by the Fed will fuel a flight away from risk and interest rate sensitive assets to safe haven assets. It feels to me like we are in the early stages of this change in mentality, but as always with markets, time will tell.
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