For those of us who grew up in the 1970s, inflation was a part of our childhood, just as the Covid-19 pandemic is likely to be for young people today. We are a generation still living with the scars and paranoia of an uncontrollable rise in everyday prices. But to have a perspective on today’s inflation, we need to look back at a formative experience we would rather forget.
In the 1970s, through policy, markets, and psychology we allowed inflation to become entrenched. The difficult economic times were preceded by a period in which the economy appeared to boom with a temporarily strong economy and low unemployment numbers in 1972. By 1980, inflation roared to 14.8%. Central bank policy, supply / demand imbalances, and market psychology all contributed to this phenomenon.
The Federal Reserve did not have its present-day dual mandate to promote price stability and maximum employment until 1977. Its resolve to fight inflation finally came in the form of President Carter’s appointment of Paul Volcker as Federal Reserve chair in 1979. Volker brought with him tough medicine. He instituted a brutal policy of tight money, and not only accepting the possibility of recession, but deliberately inducing a significant economic slowdown by raising interest rates to the double-digits and with it the highest unemployment rate since the Great Depression.
But Volker’s policy eventually achieved its objective: returning runaway inflation back to the low single digits.
When Ronald Reagan arrived in 1981, he signed the Economic Recovery Tax Act (ERTA), a package of tax and budget reductions that set the tone for the administration’s economic policy. The most important provision of the 1981 tax cuts was indexing tax brackets to inflation.
When I began in the business in the mid-1980s, I worked for a money manager who was primarily a stock manager. But his top holding was 30-year Treasuries with an average yield of 12.41% in 1984. He was even paying a premium. Today, in 2022 those same treasuries are yielding around 2.70%.¹ Would you be willing to lock in a guaranteed 12.41% return, by the strongest credit source ever known (US Government), for 30 years? It’s a simpler question today, but less so when inflation is 14% and rising.
Even recently, I have met with numerous clients who have told me stories of how the interest rate on their first mortgage in the 1970s was around 15%. And it was a time I’ll never forget when my father, a real estate developer, narrowly escaped bankruptcy. Money markets even paid 14% interest! These borrowing rates were all driven by inflation.
Today, we are playing into inflation, especially with regard to rising oil prices, supply chain constraints, and a tight labor market. But there are remedies today that didn’t exist in the 1970s. For example, we have ample capacity to pump oil in the U.S. and Canada and increase production. Years of low oil prices and restrictive policies have put a lid on this production rise currently. It is reminiscent of what The Wall Street Journal described in January 1986 when reviewing the inflationary period of the 70s: "OPEC got all the credit for what the U.S. had mainly done to itself."²
Another difference is that we have a counter measure already in place. It is an economy driven by technology and innovation powered in large part by the arrival of the internet in the mid-1990s and the rapid evolution of the microchip as perceived by Moore’s Law. Innovation creates new wealth, reduces costs for businesses and consumers, and raises the living standard of future generations.
The complexion of our economy is also very different today. In 1980, the Energy, Materials, and Industrials sectors made up almost 50% of the S&P 500. Today those sectors account for 15% of the S&P 500, while Information Technology, Communication, and Healthcare account for 50%.³ These sectors, where the primary business model provides advances in digital technology and other innovations, continue to surprise to the upside. And the offshoot of their products is inherently deflationary.
Economists have long recognized that digital goods and services typically reduce both actual and measured inflation. This is likely why reported inflation has undershot the Federal Reserve’s target for inflation over the decade from 2010 – 2020. As consumers use more digital goods and services, they pay lower prices than they did previously, and they experience smaller price increases going forward. In addition, digital tools are often prerequisites for productivity enhancements, supply chain improvements, and cost reductions on the supply side that result in reduced prices for consumers.
This remedy was not widely available in the 70s. Instead, our response back then was gas rationing, 55 MPH speed limits, and finally, the tax cuts instituted by Ronald Reagan. Reagan stated, “People who think a tax boost will cure inflation are the same ones who believe another drink will cure a hangover.”⁴
Asked decades later to name the most important legacy of the Great Inflation, Federal Reserve Chairman Paul Volcker replied: “Don’t let inflation get ingrained. Once that happens, there’s too much agony in stopping the momentum.”⁵
So, as we deal with the pain of rising inflation once again, I am reminded of Volcker’s statement on “becoming ingrained.” It is very difficult to predict what the exact inflation rate might be in the future, but it is easier to recognize all the discussion around inflation from small businesses, the media and politicians today. In fact, almost 90% of Americans are now worried about inflation.⁶ It is interesting to note that all of this coverage did not happen when inflation was undershooting the Federal Reserve’s target during the 2010s.
Yes, now all eyes will be on Washington as it reacts to the headline inflation numbers. The leadership Americans will be looking for to curb inflation will be that of Federal Reserve Chairman and its board members. We will all be watching closely heading into the Fed’s March meeting. The market has gone from pricing in two interest rate hikes in November 2021 to nearly six hikes today. We also see line of sight for inflation to decline fairly consistently over the next 12 months, declining from 7% in January to 4-5% by the end of 2022, and the bond market is pricing expected inflation over a three-year period to return back down to 2-3%.⁷
Against this backdrop, it will be interesting to see if the recent tough talk on interest rates will hold. Powell’s claim that the Fed is data-dependent in their decision-making will play a role in whether they proceed with the raising of interest rates or if they pivot more toward normalization of the balance sheet.⁸
While the result of any action by the Fed is still to be determined, we can learn a lot from historic inflation during the 1970s. Borrowing a headline from our Chief Investment Officer Michael Aroesty’s recent Q4 2021 Market Commentary, it’s time to “look back with a view forward.”
Thanks for reading.
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David B. Root, Jr.