July 22, 2022
What to Watch - Inflation Now vs. the 1970’s
Despite aggressive efforts from the Fed, inflation continues to surprise to the upside. Last week’s U.S. Consumer Price Index (CPI) print of +9.1% year over year, marked the 25th consecutive monthly increase for the index and a gain of 0.5% from the previous reading. Arguably, the two biggest questions for the market continue to be, “When will inflation peak?” and, “How long will it take for it to come down to a reasonable level?”. While we acknowledge there are many differences between today’s environment and that of the 1970s (e.g., lower wage growth, single digit interest rates, Fed taper), inflation has been following a very similar path. As such, we believe the historical context is helpful to appropriately assess and manage risk.
The Fed had to hike rates…and that still did not work
Inflation started to rise in 1972, and the Fed began hiking rates shortly after. Over the next ten years, the policy rate rose swiftly and significantly, from around 4.5% in 1972 to nearly 13% in 1974, and finally up to ~19% in 1980, at which point inflation finally came down to reasonable levels. At present, the Fed Funds rate sits at 1.58%, up from 0% last year. In comparison, when CPI hit 9% in the 1970s, the Fed had already hiked rates from ~4% to ~10%.
The present disconnect between CPI and the Fed funds rate continues to shine light on just how far behind the curve the Fed may actually be.
Source: Bloomberg LP as of 7/13/2022
It took three recessions and the “Volker Shock” to fix the issue
Fed Chairs Arthur Burns (1970-1978) and William Miller (1978-1979) both aggressively tightened rates, but CPI never came down below 5% under either leader. It wasn’t until Chair Paul Volker tightened the supply of money and intentionally incited two recessions that inflation finally subsided.
This time around, the Fed is aggressively hiking interest rates while shrinking the size of its balance sheet. However, they are also battling the highest supply of money the US has ever seen. Current supply is ~36% higher than it was pre-pandemic.
Source: Bloomberg LP, 1/1958-5/2022
Employment was not a leading indicator of recession in the 1970s
Employment data typically deteriorates prior to an economic recession, but that wasn’t the case for any of the three recessions that occurred from ’73 to ’82. As shown in the two charts below, both higher unemployment and lower payrolls were trailing the recession.
Currently, unemployment is very low and continues to be a point of focus for the Fed.
Source: US Bureau of Labor Statistics, 1972-1982
Source: US Bureau of Labor Statistics, 1972-1982
The Takeaway
We remain cautious and believe that taming inflation may in fact be a drawn-out process that comes with elevated market volatility. It is, however, encouraging to note that from 1972 to 1982, amidst all the turmoil, the S&P 500 Index still produced a positive annualized return of 6.5%. With this in mind, we continue to focus on the balance between managing near term drawdown risks and long-term growth.
Consumer Price Index (CPI): a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services
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