The 1970s: It's Deja Vu All Over Again!
Updated: Oct 26, 2021
Yogi Berra - Navy veteran, baseball legend and humorist (1925-2015).
Here is our deep dive analysis on inflation. Are we about to experience 1970s-type inflation in the 2020s? The short answer is no, but there are several important parallels to the 1970's and the low-inflation environment of the 2010's is unlikely to return anytime soon.
• Inflation is affected by several different factors that include government policies and consumer psychology.
• The 1970's experienced many different inflationary factors at the same time.
• Today, some of these important inflationary factors support a higher inflation story, but not all.
• Bottom line, we expect inflation to be in the 3-5% range for the next few years, absent a supply chain caused recession.
• If Congress dramatically increases spending and banks start lending aggressively, higher inflation of 5-10% may emerge.
• If Treasury Bond yields begin moving up past 2%, the Fed may feel compelled to chase the interest rate rise. The government can't let interest expenses eat up the federal budget.
Monetary Policy is Highly Inflationary
Monetary Policy is set by the Federal Reserve. They use two primary tools to communicate this policy to the market and economy: the Federal Funds overnight lending rate and bond market interventions. Both tools are used to change lending incentives and credit availability in the economy. During the Great Depression, zero interest rates and bond purchases were used to offset the deflationary effects of bank failure and economic contraction. These tools were used again after the Great Recession of 2008. In the 1960-1970s, the Federal Funds rate was the primary tool for influencing policy. This interest rate moved all over the map as the Fed tried to dampen inflation while permitting economic growth. Politics played a role in the weak Fed response to inflation as both Presidents Johnson and Nixon were known to lean on the Fed for easier policies to assist their re-election campaigns. So, what did the Fed do in the 1960-1970's time frame? In the 1960's, the Fed Funds rate was generally above the broad rate of inflation. This was prudent. However, as inflation began to run higher in the 1970's, the Fed Funds rate matched or fell below inflation. Even as inflation ran higher, the Fed was reluctant to stop it. By 1980, the Fed raised interest rates well above inflation to finally stop the inflationary spiral, but it came at the cost of 2 brutal recessions in the early 1980's. During the 2010's, the Fed held short term interest rates close to zero for most of the decade. This is an inflationary policy. The current interest rate posture in an environment of 5% consumer inflation is more inflationary than any period in the 1970s.
Government Spending Is Highly Inflationary
Congressional spending plays a major role in inflation depending on whether the economy is contracting or expanding. For example, there are several special programs that are used during recessions to keep consumers whole and spending. Unemployment insurance is a perfect example of this type of counter-cyclical spending.
However, excess government spending when the economy is expanding creates high demand for limited resources. The market's response to this is higher prices and shortages. During the 1960's President Johnson rolled out his Great Society welfare programs with broad bipartisan support. Along with Vietnam War expenditures, federal government spending saw a dramatic increase in the late 1960's that carried into the 1970's.
Government spending growth 2000-2020 was much more muted until the pandemic. As you can see in the second chart below, government spending exploded in 2020 to counter the effect of the national pandemic shutdown. While many of the programs are rolling off now, Congress is debating a new batch of programs that may permanently increase spending, just as the Great Society programs expanded spending in the 1970's. This is all very inflationary.
The Bond Market Is Not Worried
The bond market is not currently worried about inflation. Long term Treasury bond rates have been in a downtrend for many years. Despite the recent high inflation readings, these yields have not moved by much. There is certainly some pressure being applied by the Fed to long term rates. Their quantitative easing program ensures that there is a large, price-insensitive buyer for all the debt the federal government is selling to fund operations. This was not the case in the 1960-1970's. During these two decades, long term interest rates were on a determined march higher as the government refused to take any steps to halt the inflation.
Bank Lending Activity Is Deflationary
There is a large focus on Fed behavior when it comes to credit policy. However, Fed policy doesn't flow through to the broad economy unless the commercial banks lend money. The 1960-1970's saw a dramatic increase in lending activity as many bank laws from the 1930's were modified to permit more lending. This was quite deliberate and began with encouragement from President Kennedy. During the 1960's, bank lobbyists were a busy bunch. Here is a brief list of some laws and developments that helped the banking system increase their lending. This directly increased the broad money supply and supporting the monetary inflation of the 1970's. Loan growth was 10-11% year over year during this time period.
The last two decades have seen bank laws and regulations that have impeded the banking system's ability to lend. Most of this occurred after the Great Recession and financial crisis. Loan growth in the 2000's was 3%, but increased to 6% as the economy recovered from the financial crisis. We are watching the significant decline in loan activity during 2021 quite closely. It is likely a normalization from the pandemic, but it could bring a huge hangover after the 2020 high.
Consumer inflation expectations are rising dramatically
Inflation has a psychological effect on the economies that experience it. Higher prices beget higher prices if people expect them to continue going up. The burden of inflation falls heavily on the lower and middle classes as their costs rise faster than incomes. Businesses suffer if they cannot raise prices to cover their costs, hurting earnings. Whether this Narrative cycle is broken is a choice the government must make. It doesn't matter if it is the central bank, legislature or executive branch, someone in power is going to have to say let's stop inflation now. The 1970-1980's time frame shows how much pain was imposed on the economy to suppress inflation. The Fed kept interest rates well above inflation expectations for many years to kill the inflation cycle of the 1970's. Today's leaders at the Fed are interested in encouraging inflation and have a policy that reflects this view. It will take a change in political will for them to significantly change policy. In other words, if inflation starts costing incumbent politicians votes, then we will see them fighting inflation rather than supporting it.
Demographics are deflationary, but maybe inflationary
Demographics play a role in inflation because jobs and spending are involved. One helpful statistic is the labor force participation rate. It is a measure of national employment as a percentage of the total working age population. During the 1960-1970's, women made huge advancements in the workplace. You can see this in the large rise in female participation 1960-1995. As they earned money, more dollars were created to spend in the economy. This contributed to the inflation of the 1970's. Conversely, in the last two decades, labor force participation of both men and women has declined. Fewer jobs mean less money; less money means less inflation.
There is another Narrative that says participation is falling because real wages are falling and people would rather not work. It's not worth it. Think about how inflationary this could become if trade frictions or disruptions bring jobs back onshore. Companies will have to pay up to get people off the couch. We see a glimpse of that with all the "help-wanted" signs.
Imports May Become Inflationary
It's no surprise that we import many products into our country. The port congestion in California and supply shortages we see in day-to-day life are a new reminder that we are dependent on factories that are very far away. Will this contribute to inflation? Maybe. If something happens in the export countries that forces their costs higher, that will make imports more expensive contributing to inflation. In China for example, there are reports of power shortages, expensive raw materials, transport problems or political problems with trade partners. These factors may all cause import inflation here in the US.
The Dollar Is Not Creating Inflation
There is a Narrative that the Fed is printing so much money it will cause the US Dollar to lose significant value and cease its role as the world's reserve currency. From the currency market, there is very little evidence of this. The dollar has been falling gradually for decades, but in recent years has been strengthening.
Inflation Isn't Good For Stocks
Why is this analysis important? Because with a little push, we may find ourselves in a high inflation environment that will not be good for stocks or bonds. Stocks and bonds are strongly influenced by Federal Reserve and Congressional willingness to provide stimulus. If the Fed changes policy to suppress inflation rather than interest rates, we expect a very volatile investing environment similar to that of the 1970's. During this period, he stock market chopped sideways for over 10 years while inflation ate away at real returns.
For investors, there are several key signs to watch out for if you want to preserve your portfolio's value (they haven't happened, yet): 1. A new Narrative that Washington must "fix" the inflation problem. 2. 10-year Treasury bonds moving about 2%. 3. Passage of a large stimulus bill. 4. A Congressional initiative to "reform" bank laws to help the economy. All of these will complete the missing elements for a 1970's-style inflationary environment. Thank you for reading our research on inflation. It is a example of the thought process we use while managing your portfolios! If you would like to see our regular market commentary, follow us on Facebook or LinkedIn . If you prefer email delivery, let us know and we'll put you on our distribution list. Robert Lloyd, CFA®
Chief Investment Officer
Lloyds Intrepid Wealth Management
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