Due to the CPI-inflation we are experiencing today, market participants are starting to draw strong parallels with The Great Inflation period from 1965-1985 (“TGI”). It is always a point of suspicion for us when the foundation for a market narrative is based on comparing the contemporaneous period to only a single period in history. A full treatment of the differences in periods involves a lot of work and it is often, instead, more tempting to run with the quickest explanation to support one’s fears. We hope to provide a proper comparison of the periods and explain why inflation will not persist in the current environment as it once did in TGI.
Leading up to the TGI, inflation hovered around 1% until 1966 when it breached 3%. From there, headline inflation took a volatile path to its peak of 14% in 1980 before declining to 3.5% several years later. This was a turbulent time in America’s history: frequent recessions, civil rights movements, administration scandals, a costly Vietnam war, and a general loss of public confidence in America’s institutions. Today, as so in TGI, the risk the Federal Reserve faces is that inflation expectations will become embedded, eventually wreaking havoc on the public’s real incomes, company income statements, and the economy. To mitigate the possibility of this outcome, the Fed has aimed all its artillery at the market by telegraphing a salvo of rate hikes and a firm commitment to reduce the fed balance sheet by essentially canceling the repayment of debt proceeds instead of opting for reinvestment. The Fed is trying to walk the tight rope of quelling inflation without negatively impacting employment metrics or general economic progress. The fear is that the Fed fails miserably and accelerates the US into a recession before the stability of prices is achieved, thus making a return to Fed dovishness a difficult task. In addition to this, there is the outside chance that tightening reveals “who has been swimming naked”. When times are good, there is always the unproductive extension of credit. When times are bad, excesses in those areas of the market can lead to distressed selling. In a financially interconnected world, this leaves open the possibility of contagion risk that may give rise to any number of black swans: International dollar illiquidity, emerging market busts, the rapid increase of bond yields etc. These panic-induced selloffs in the financial economy could metastasize into the real economy forcing the Fed to make the hard pivot to extreme dovishness, undermining their ability to mitigate inflation.
While it is difficult to tell what the knock-on effects of monetary tightening will be, the silver lining is that the Fed will be granted more flexibility because disinflation is on its way. The best way to support the disinflationary thesis is by providing a strong contrast to the inflationary environment of TGI.
How We Got Here
In 2020 & 2021, the Fed and Fiscal authorities provided close to 5 trillion in stimulus to state and local governments, corporations, and consumers. The overwhelming majority of these funds were created out of thin air by the Federal Reserve and handed to the Treasury to dole out in return for debt assets on the Fed balance sheet. As a result, the Fed balance sheet ballooned from ~4.2 Trillion before COVID to ~8.9 Trillion today. M2, which is a measure of the money supply in an economy and has averaged annual growth of roughly 6% since 1980, rose 25% in 2020 and 12.7% in 2021. At the same time, consumers were forced to stay in their homes, causing an abrupt demand shift from services to goods.
Although the link is not always a direct one between the expansion of the monetary base and subsequent inflation, we know from historical precedent that whenever inflation has manifested it is always preceded by rapid increases in the money supply. Said differently, rapid increases in money supply are a necessary but not sufficient condition for the onset of inflation (Figure 1 below is an example of this unclear link). In the present case, the stimulus was overkill in that it more than offset the output gap – the difference in current economic output vs output at full employment. Paradoxically, disposable incomes went up, and, more importantly, authorities did everything they could to telegraph further stimulus to consumers and ensure employers would receive grants and loans as long as they kept their payroll intact. For the majority of the public, this created a general feeling of economic security that was a contributing factor in increasing the aggregate propensity to consume. This is important to understand and gets left out when economists discuss the causes of inflation. Fiscal deficits, money supply, economic growth, and debt levels receive the deserved attention but without a proper treatment of the social element, those factors are in and of themselves incomplete explanations. For inflation to be given a chance to occur, either: a) a general feeling of economic security or b) general fear that money will be worth just a bit less tomorrow must be in place. Stimulus coupled with economic security set the backdrop for a consumption squeeze that was followed by supply chain constraints unable to adjust quickly to the massive increase in demand for goods. Shortages often lead to increased shortages in the short term as those experiencing delays made sure to pull more of their spending forward. As of the latest 2022 April CPI readings, headline and core inflation sit at 8.3% and 6.2% respectively.
A Faulty Comparison
We are firmly in the camp that inflation is transitory and over-drawing parallels from the inflationary environment of TGI is a mistake. There are similarities such as high levels of deficit spending and supply shocks yet the differences are critical enough to render drawing conclusions pointless. In our view, the two key differences between the inflation of then vs today are: 1.) Market dynamics and 2.) Fed Credibility.
To being with, the dynamics of the demand side and supply side are vastly dissimilar. In 1965, over a third of the labor force was unionized and COLA adjustments assisted to increase domestic wages by almost five times by the mid-80s. Producers and consumers were caught in a “wage & price spiral” where an increase in prices was followed by a direct increase in wages and so on. The correlation between wages and prices was much higher then. To combat this, Nixon, who fundamentally understood price controls do not work, found the option too politically tempting and instituted a range of price controls. Predictably, this was popular with the public but the lack of proper price signals to the marketplace created shortages and exacerbated inflation when they were ultimately removed in ‘74.
Collective bargaining and price controls ensure that the self-repairing aspects of the free-market function sub-optimally. The best weapon against the instability of prices is a healthy free market economy. One thing Nixon did do right during his administration was to provide a boon to globalization by aligning China with the West. The collapse of the Soviet Union in 1991 was the last domino to fall, and the world has been in a rapid globalization phase ever since. To quote economist Charles Goodhart, “The numbers associated with this integration are staggering. Counting just the potential workforce, the working population in China and eastern Europe (aged 20–64) was 820 million in 1990 and 1,120 million in 2014, whereas the available working population in the industrialized countries was 685 million in 1990 and 763 million in 2014. That represents a one-time increase of 120% in the workforce available for global production.” The takeaway is that the global supply base today vs the supply base of TGI are light years apart in terms of size, speed, and technology. There are those that believe the era of peace that ushered in this globalization is on the decline. While challenges do exist, we believe countries have no choice but to continue to bet on globalization. Countries that begin to look inward risk economic instability and will be outcompeted by those that don’t.
In a well-functioning free-market system, without continuous missteps in monetary and fiscal policy, sustained high levels of inflation cannot exist. An increase in prices would be met by an adjustment in supply and in the event supply shocks rendered prices high for a period, consumers would adjust their budgets and spend less on other items. Free markets repair themselves through the pricing and production mechanism and our free market of today is more competitive and considerably healthier.
Since sustained inflation was not an issue in the country’s history leading up to TGI, the central bank at the time was less focused on inflation and more fearful of a depression. As a result, policy responses lacked consistency and would quickly reverse course at the onset of recessionary pressures. Arthur Burns, a well-respected economist who chaired the Fed from 1970-1978, started raising rates in 1970 to control inflation but abruptly about-faced at the first sign of an economic hiccup. This feckless behavior would repeat again in ’73 (See Figure 2 below). It certainly did not help that he believed inflation was not primarily caused by monetary forces and cost-push factors were more to blame. It should come as no surprise that he was a strong advocate for Nixon’s highly counter-productive wage and price controls.
At the time, the Fed operated less as an autonomous entity and more as a political tool of the presidency. It wasn’t uncommon for Federal Reserve brass to have continuous meetings with the President regarding the financing of deficits and provide tacit consent to keep interest rates low – not just to ease Treasury funding but also to help with reelection campaigns. Although the Fed will never be free of political pressure, they are considerably more independent than during TGI period. This independence began with Paul Volcker who restored confidence in the Fed by successfully waging the war against inflation. Volcker was assisted by Presidents Jimmy Carter and Ronald Reagan as they began a culture of not tarring and feathering the Fed when it began tightening and instead choosing to respect its autonomy. The gravitas of Alan Greenspan also helped significantly – he was consistently reappointed by presidents on both sides of the aisle. With this hard-won independence, the Fed today has more autonomy and market participants extend them ample credibility. As we write this article, the 5-year break evens, which signal expected inflation, have come down to 2.9%. Markets have tightened well ahead of the Fed’s announced rate hikes. The 10-year treasury rate and 30-year mortgage rates almost doubled from where they began the year. Because of this “pricing in” of expectations, the Fed is less behind the curve than market participants believe. Could the Fed lose credibility in this fight against inflation? Although this is a risk, the Fed understands the lessons from TGI and does not intend to repeat the same mistakes. The belief in markets that the Fed is on the case helps to reduce inflation expectation which subsequently helps reduce actual inflation.
We are convicted that disinflation is imminent but less so on what the “transitory curve” looks like. In other words, are we going to get back to 2-2.5% inflation by the end of 2022 or 2024? Although we do not have a good estimate on timing, we believe this could happen faster than market participants believe. There were several cases in TGI where inflation fell rapidly due to reduced demand even in the face of supply shocks. Gradual disinflation will help markets breathe a sigh of relief as the Fed is afforded more monetary flexibility. How will we know if our thesis is wrong? Assuming responsible monetary policy, if core inflation remains stubbornly flat or increases over several quarters this will cause us to rethink our stance. In the meantime, although stocks are still not screening cheap, we are looking to add quality names to our portfolio.