When it comes to inflation, it’s not déjà vu all over again
The writer is global chief economist at Morgan Stanley
Loose monetary policy, expansionary fiscal policy, rising inflation and then a rise in oil prices – it is very difficult to resist the temptation to draw parallels with the 1970s.
I suggest, however, that the current conditions are not a repeat of that decade, which was doomed to end in a deep, policy-induced recession that is dragging much of the world down. There are several meaningful reasons why today is not yesterday. That said, even if we don’t relive the 1970s, we’re not on an easy road either.
In the second half of the 1960s, the US economy tightened with stimulative fiscal and monetary policies. The first oil price shock in the early 1970s fueled further inflation. So far almost a comparison with today, but the differences quickly become apparent.
The economy’s reliance on oil is now significantly less than it was in 1970 – not least because services now make up a much larger proportion of gross domestic product. Now that the US has become the largest oil producer in the world, there is now actually a boost to at least part of the economy.
Of course, inflation is the percentage change in prices, and viewed through that lens, the current oil price shocks are nowhere near what they were five decades ago.
At the end of 2019, just before the start of the Covid-19 pandemic, oil was near $60 a barrel; it’s now about double that price. In 1970, West Texas Intermediate, the benchmark for US oil, was trading at just over $3 a barrel. By 1974, after the first soaring in inflation, it had risen to over $10 a barrel – a threefold increase in price. In 1980 it was approaching $40 a barrel, or more than 10 times its price at the beginning. A doubling of the oil price is a lot; increasing by an order of magnitude is quite another.
In the 1960s, inflation began to be broad-based, with the prices of both goods and services rising. Inflation started narrowly last year, with demand for consumer goods soaring as global supply failed to keep up in the face of a sclerotic supply chain hampered by the coronavirus pandemic.
Of course, inflation has now spread across all categories of the consumer price index, but commodity inflation seems poised for a retreat. Take a look at recent earnings reports from retailers who are overstocked and trying to fix the inventory. Overspending on consumer goods appears to be on the cusp of correcting inflationary pressures, and with it at least some of the inflationary pressures.
Nevertheless, the current magnitude of inflation cannot be denied, and one of the fears of the 1970s is that it could become entrenched in the economy. Indeed, some of the long-term measures of inflation expectations are now beginning to rise.
But consider this: In 1970, everyone 40 years of age or older had already seen three periods of inflation comparable to today’s. Today’s 40-year-olds have seen nothing quite like it and are, in fact, more familiar with deflationary trends than inflation.
In 1970 the thought must have been: “Here we go again”, while today the question is: “What now?”
Finally, in 1979, Paul Volcker, former chairman of the Federal Reserve, began to squeeze a decade of inflation out of the US economy by sharply raising interest rates and triggering a recession. (I’m happy to disregard the semantics of whether the Fed has raised interest rates or merely limited money growth; that’s an indiscriminate difference in this case.)
But by then there had been a decade of high inflation, deeply entrenched in the mindsets of businesses and households all too familiar with high inflation. The effort required to break that cycle was very different from what it takes to rein in today’s excesses.
And that point leads to perhaps the biggest difference of all. We can learn from history if we want to.
Piles of paper have been filled out explaining how and why “Great Inflation” took root, but all the analysis features too-easy monetary policy figures prominently. Witnessing the cost of Volcker’s disinflation, current Fed Chair Jay Powell has already begun to meaningfully tighten policy. Of course Powell will need skill, determination and not a bit of luck, but – in stark comparison to Volcker’s predecessor, G William Miller – he knows what happens when high inflation is left unattended.
But even if I am right that we are not experiencing a repeat of the 1970s, the road ahead is not rosy. Inflation is undeniably very high, and much of it is in core services, driven by an economy trying to buy far more than it can comfortably produce.
Any empirical estimate of how much slack needs to be created in the economy to reduce structural inflation is a very unpleasant trade-off. Either the Fed can quickly push back inflation by triggering a meaningful recession, although probably a milder recession than in 1979, or it can slow the economy into recession, but live with elevated inflation for years to come. Judging by the forecasts made by the members of the Federal Open Market Committee at their most recent meeting, they have opted for the latter path. But like I said, luck will also play a part.