The debt financing of the Vietnam war and great society programs followed by the Fed adding fuel to the fire with expansionary monetary policies in 1968 set the basis for the seventies inflationary spiral. Then, in 1971 these so-called “guns and butter” policies forced the U.S. dollar off the gold standard further contributing to the inflation spike.
The double-digit inflation that followed came in two waves as Figure 1 shows. The first wave arose as both adverse global weather conditions caused food prices to escalate and OPEC quadrupled oil prices. Then the U.S. terminated wage/price controls in 1974. These factors Fed on the inflationary base of the late sixties to produce the first wave of double-digit inflation. The same two sources, food and energy, also produced a second wave of inflation later in the seventies. In addition, higher mortgage interest rates, resulting from escalating inflation, also brought additional inflationary pressures.
These sharp upward price movements suggest double-digit inflation in the seventies arose from special factors feeding off the fiscal and monetary mistakes of the sixties. Longer-term, these special factors can impact the base rate of inflation if wages also accelerate. In the seventies, compared to the present, unions, particularly industrial unions such as auto, steel, and coal held sway. As a result, their contracts contained cost-of-living agreements (COLA) adding inflation adjustments to annual hourly wage increases. Since the seventies, the influence of globalization and technology advances reduced blue-collar jobs and union power. These varied influences reduced wage and salary share of gross domestic income and their past and future influence on the rate of inflation (see Figure 2).
The snap-back from the pandemic and the resulting relief programs will likely prove key to increasing inflationary pressures. The pandemic produced historic fiscal responses; the five pandemic relief programs totaled roughly 25% of GDP compared to 5% aid after the great financial crisis (see Figure 3). For perspective, according to the Manhattan institute, the U.S. spent $4.8 trillion in 2021 dollars to fight world war ii. In a shorter period of time, the U.S. spent over $5.5 trillion fighting the pandemic.
Even before checks from the most recent $1.9 trillion program arrive, consumers increased their excess savings to total close to $2 trillion, admittedly, some of this savings increase results from forbearance programs for rent and mortgage payments. Nonetheless, excess savings represent consumer spending power as they emerge from their caves and open their wallets. The lengthy depression of the thirties scared the consumer psyche for some lengthy period. The relatively short pandemic in comparison, means the memory of normal remains front and center. If that proves correct, consumers’ postponed spending and recently augmented government financial support will likely power the snap-back into 2022.
With the additional flow of Federal checks to consumers, economists continue to ratchet up their economic growth forecasts for the snap-back likely to begin in the second quarter. For the year, Merrill Lynch and Goldman Sachs economists project GDP growth to reach at least 7% annualized. This would be the sharpest growth for the U.S. economy since 7.2% in 1984. With comparisons against last year’s record second quarter economic collapse, inflation should also rebound to levels over the Fed’s goal of 2% in the upcoming quarter.
Due to fears of virus spreading, consumers avoided crowded restaurants and other similar consumer activities (see Figure 4). As a result, many smaller consumer service suppliers such as restaurants disappeared lacking financial resources to survive. With vaccinations building consumer confidence, it would not be surprising to see an initial explosion of spending on consumer services. With consumer services supply cut by nearly 300,000 small and medium sized businesses closed, prices could rise sharply. Low product inventories will also add to these inflationary pressures (see Figure 5). Net result, higher prices will reflect these initial imbalances in both goods and services. Short-term, these inflationary pressures reflect the good news of consumer spending, powering an economic snap-back,
With the economic turn, economists and investors will then begin debating whether inflation will prove transitory once snap-back momentum abates likely sometime next year. Fed governor Lael Brainard said on this subject: “a burst of transitory inflation seems more probable than a durable shift above target in the inflation trend and an unmooring of inflation expectations to the upside.” Figure 6 shows inflation expectations shooting up—key to judging the potential for “unmooring of inflation expectations.” The Fed’s goal of running the economy hot will not make it easy for the Fed or investors to judge the transitory nature of inflation resulting from the snap-back. More likely, investors will wait to see inflation pressures subsiding before giving the Fed the benefit of the doubt. The old “saw”, don’t fight the Fed may prove the reverse as the Fed fights the financial markets.
Wages comprise roughly 70% of business expenses. Inflation beyond the snap-back, transitory or not, will therefore depend importantly on whether average hourly earnings accelerate rapidly. According to the bureau of labor statistics, roughly twenty-five percent of U.S. employment supports office workers and their needs in major cities. With working from home growing, demand for such office support services, particularly in major cities, will likely decline. With reduced demand for such services, wage acceleration seems unlikely for that large sector of the U.S. work force. Unlike the seventies, unions show little power in private industries. With these changes, despite population growth slowing and increasing numbers of retirements, wage pressures will likely remain under control moderating inflationary pressures for some period post the snap-back.
During a lecture in 1970, Milton Friedman, the noted Rutgers graduate, said “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Despite Friedman’s comments, inflation remained relatively low over the last decade. Declining velocity for “money” muted the Fed’s expansionary monetary policies. At the same time, the Fiscal Impact Measure maintained by the Hutchins center at Brookings showed that fiscal policies acted as a drag on economic growth over the last decade (see our commentary 2/10/2020). Experience over the last decade, therefore, suggests that inflation depends not only on expansionary monetary policies but also stimulative fiscal spending.
Since the great recession, the Fed “Federalized” financial markets with its large-scale financial asset purchase programs. Adding to continued stimulative monetary policies, the administration looks to initiate further substantial stimulative programs such as infrastructure spending that could total in the neighborhood of $2-4 trillion over 10 years. Higher tax rates as well as increased borrowing will fund part of these costs. The size and breath of recent spending legislation reflects the democratic party tilt to its progressive wing. With this tilt, tax rate increases could reach higher than currently expected.
Funding infrastructure and other growing programs including social inequality will also require even a greater partnership between treasury and the Fed. This combination of two factors that led to double-digital inflation in the seventies— rapidly increasing deficit spending and easy monetary policies. This redux likely led several leading economists to express such concerns. Fortunately, and unlike that prior period, the U.S. faces no inflationary pressures from funding a major war—no guns but plenty of butter.
Combining very accommodative monetary policies with growing budget deficits provides the potential for producing higher levels of inflation (see Figure7). This potential might be realized when new major fiscal programs reach the major funding stage likely beginning sometime in 2023. At current low interest levels, funding the debt may now prove less burdensome than in the sixties and seventies. Conversely, a much lower debt burden existed back then. In comparison, Federal debt grew three times its percent of GDP (see Figure 8). As outlined in our recent commentary (2/10/21), this increasing debt produces diminishing returns to GDP growth and therefore may prove an unsustainable level.
Cyclicals/Value—the recent passage of a larger than expected covid package likely extends the economic momentum into the first half of 2022. With that longer horizon, our recommendation of cyclical/value stocks continues (see our commentaries 9/17 and those that followed).
Commodities and Oil—stimulative monetary and fiscal spending programs globally joined by the current recovery in china could lead to a synchronous rebirth of global growth later in 2021. This outlook should benefit many hard commodities as well as oil. Underinvestment in production capacity for both groups should prove key to their attractiveness—similar to earlier in this century.
Growth, Pricing Power, and Lower Labor Costs—in the second half of this year, investors will need to judge both how far this year’s likely economic momentum will carry into 2022 and what will then be the inflation outlook. If the economic outlook for the second half of 2022 projects a return to slower economic growth, then investors may return to faster growing companies. At the same time, if inflation also raises its ugly head, then investors will likely seek out companies with pricing power as well as those with lower labor costs.
Fixed Income —having Federalized fixed income markets, the Fed may still hold off attempting to moderate the yield curve’s upward tilt unless unexpected pressures result. Nonetheless, with that outlook, investors should stick with shorter-duration fixed income investments. This will avoid the price risk longer duration debt faces from potentially rising interest rates.
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