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.
Market Fears
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.
Market Dynamics
To being with, the …