Inflation JLGutierrez/E+ via Getty Images
Inflation has become a major concern in all corners of the economy and in the financial markets. After a decade of relative price stability, the past year has shown an eruption to the highest rate since the late 1970s and early 1980s. Importantly, though, inflation has not been endemic to the U.S. economy. Rather, it is shown to be temporary and associated with external shocks, policy errors, and war.
Chart I attached traces inflation back to shortly after the Revolutionary war period with shaded areas depicting war time periods. To be sure, data collection and quality is suspect prior to the two World Wars. But working with what is available it is interesting that over the 220 year history 191 years of relative peace showed consumer prices averaging 0.6% annually. The 31 years of war and conflict showed a CPI average annual rate of 7.4%.
During the War 0f 1812 the CPI began at 1.5% but rose to 20.3% in 1813 and then a slower 10% in 1814. By 1815 the rate was -12.5% and remained negative or zero through 1821. The Mexican American war began in 1846 with CPI inflation at 1.3% in 1846. Price inflation rose to 6.5% in 1847 only to fall back to around 3% in 1848-49.
In the years leading up to the Civil War inflation was at zero, but it then spiked to a high of nearly 25% annually in 1863-64. In 1865 it fell back to only 3.8%. Peace brought an extended period of price stability until war broke out in Europe in 1914. The U.S. did not enter the war until 1917, and in 1915-16 the U.S. averaged about 4.5% inflation. Prices then spiked to an average rate of about 16% in the 1917-19 period. The flu pandemic emerged at this time, contributing to price pressures.
World War II began in 1939 with the U.S. formally entering in 1941. Inflation ran at about 7.5% in 1941-42 but then price controls and rationing distorted the true inflation picture. Upon the end of the war and the termination of price controls inflation was around 8%, falling into negative territory in 1949. The Korean War from 1950 to 1953 also showed an acceleration as did the Viet Nam War. Inflation was negligible in the 1950s and early 1960s. The U.S. involvement in Viet Nam is generally marked as commencing in 1964 and inflation rose from an average 2% yearly in the 1964-68 period to over 5% from 1969 through 1971.
Inflation spiked into double digits in the late 1970s through 1982 as an outgrowth of the Arab oil embargo, external agricultural supply shocks, and inflationary monetary policy. From 1982 forward inflation moderated steadily until this past year when the COVID-19 pandemic and more recently the Russian invasion of Ukraine disrupted what had become a lengthy period of price stability.
With the Fed currently tightening credit in response to a spike in inflation, analysts are scrambling to draw parallels to past recent tightening cycles. Some are focusing on the 2018-19 experience when successive and prospective policy induced rate hikes led to economic weakness and a financial market meltdown. This quickly triggered a policy reversal and the initiation of interest rate cuts. Others, including ourselves, have been looking at the 1994-95 period when aggressive rate hikes in 1994 slowed economic growth and inflation, setting off a three-year period of growth, decelerating inflation, and three strong years for equity markets.
Of course, every business cycle has distinguishing characteristics which make strict comparisons suspect. In the 2018-19 period the distinguishing characteristic was an absence of inflation, giving the Fed a lot of discretion. In the 1994-95 period the distinguishing feature was a burst of productivity growth which gave the Fed leeway to focus on economic growth while making a bet that inflation and inflation expectations would remain muted.
Unfortunately, characteristics of the current period seem to leave the Fed with fewer options. In 2018 inflation was less than 2% whereas now it is above 8%. In 1995 and thereafter productivity growth was above trend whereas currently a burst of productivity emanating from the economy’s increasingly technological bent is still a forecast lacking hard evidence. Additionally, the economy’s debt load, both absolutely and relative to GDP is currently significantly higher than in those earlier periods as the government spent like drunken sailors to fight the pandemic. Further, there is now the Russian invasion of Ukraine and supply chain disruptions which are biasing up the price level in ways that make traditional monetary policy actions less effective.
In our report titled The Post Pandemic Economy: Lion or Lamb dated January 2021, we drew analogies we drew analogies to the 1918-19 flu pandemic and the subsequent decade of strong noninflationary growth. At the time we argued that the current economy is in a much different place than it was in the 1920s. Because of high debt and high asset valuations relative to the earlier period it would be unlikely that the 2020s economy would perform as well as the economy of the roaring 1920s. To date that prognosis seems valid.
The federal reserve was created in 1913 with the mission of being the lender of last resort to banks. Later it began regulating the money supply in relation to gold. The U.S. Bureau of Labor Statistics was also created in 1913 with its mission being to measure changes in consumer prices. The tools available to both agencies to accomplish these goals were archaic by today’s standards. At its inception the principal policy tool deployed by the Fed was the discount rate and historical data gotten from the Federal Reserve Bank of St. Louis. Open market operations i.e., buying and selling government securities was not used as a policy tool until 1923.
At the time of that report, we did not focus on the policy actions that immediately followed World War I and the flu pandemic. But the similarities between that period and the nation’s current circumstance are rather stark. Following the war and the flu pandemic was a recession 1n 1920-21. The recession was more severe than the Great Depression. GDP was reported to decline by 38.1%from January 1920 to July 1921 whereas from August 1929 to March 1933 the GDP decline was reported at 26.7%.
Our focus on 1920-21 is because of its proximity to World War I and the flu pandemic. During the war and pandemic, the Federal Reserve was primarily interested in financing the war with low interest rates while ignoring potential inflationary consequences. The discount rate was held at 1.25% during this period even as consumer prices was in a range of 15% -20% yearly until late in 1919.
With the end of the war and the pandemic having receded, on January 24, 1920, the Fed raised its discount rate from 4.75% to 6% - the largest single tightening move ever recorded. By the end of 1920 Chart II attached shows that the yearly growth in the money supply went from the high double digits to slightly more than 1%. And the growth rate was negative in every month from January 1921 through April 1922 when policy finally became stimulative.
Inflation responded to the Fed’s severe tightening. By January 1921 the yearly change in the CPI was -1.5% and the CPI showed steady deflation until March 1923. With typical lags the stimulative monetary policy that was initiated in April 1922 revived economic activity and presaged the long period of economic growth that identified the decade as the roaring 1920s.
In the midst of the COVID -19 pandemic monetary policy became extremely accommodative just as in the earlier period. The money supply rose in excess of 20% annually during most of 2020 as shown on the accompanying Chart III. Simultaneously more than $10 trillion of debt financed public sector spending was authorized while interest rates were held down by the fed’s balance sheet expansion. This is not dissimilar to the Fed’s actions 100 years earlier. The stimulus ignited a recovery in economic activity and with the typical lags, inflation began to pick up as well.
By late 2020 inflation measures began accelerating, but with little concern being expressed by Federal Reserve officials. Fed Chair Powell was up for renomination during this period and whether by accident or design he did not shift rhetoric or policy until November 2021 after his reappointment was secured.
Since late 2021 Chart III shows a definitive slowing in money supply growth and the beginning of a sharp rise in the Treasury two year note yield. By early 2022 money growth was in the low single digits while note yields had fully discounted multiple policy moves by the Fed. In the past few months money supply growth has turned negative and the dollar exchange rate has appreciated measurably. It is probably too soon to say the inflation is now peaking in response to these stringent policy actions, but the track record of these indicators would point to a collapse of inflation.
Having said this the recent shock of Russia’s invasion of Ukraine is a new wrinkle particularly since the region is a major producer of raw materials. It is disrupting the global food and fuel supply while negatively impacting global economic growth. With a rising risk of global recession, we suspect that sometime soon a choice will have to be made to support the global economy even at the expense of swallowing inflation. The choice will be easier if there is evidence of an easing of nonfood – non energy price pressure.
With hindsight the Fed waited too long to ease policy in the face of economic contraction in 1921 The hope is that the Fed has carefully studied its actions in this earlier period because the parallels between that period and the current period are so similar. Conventional wisdom is that the Fed is far behind the inflation curve. If past is prologue, our feeling is that the Fed may soon find that it is in front of the curve.
Investment Implications
At some point in the cycle of: high inflation causing the Federal Reserve to tighten credit enough to cause a recession, there is a time to buy Treasury Inflation-Protected Securities, known as TIPS. There is sweet spot in the cycle based on the fact that the adjusted principal from inflation is based on the prior period. As the recession is beginning there is a point in time when inflation has been high, but the contracting economy starts to lower interest rates in the bond market. That is when an investor can benefit from both the adjusted principal from past inflation and the increase bond prices from the recession. To benefit from this an investor can buy TIPS or ETFs such as Schwab U.S. TIPS ETF (NYSEARCA:SCHP) or iShares TIPS Bond ETF (NYSEARCA:TIP). When the time comes SCHP is a better choice because of its very low expense ratio of 0.05% vs 0.19% for TIP.
Chart I
War and Inflation ((BLS))
Chart II
Money CPI and Discount Rate ((FRED))
Chart III
M2 and 2-year treasury rates ((FRED))
