Inflation: 40 Years Ago and Now
Inflation: 40 Years Ago and Now
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.
Inflation is the one form of taxation that can be imposed without legislation.
Milton Friedman, 1970
Inflation is back, and with a vengeance. After decades of tame inflation with the Consumer Price Index (CPI) running at 0-2% annually, the CPI for May 2022 (year over year) hit 8.6%. This was the highest rate of inflation since January 1982. When shoppers go to the supermarket, they are in shock at the price of food and even more amazed when it costs $100 or more to fill their gas tanks. The University of Michigan Consumer Sentiment plunged to 50.0 last month — the lowest level ever recorded since the University began collecting data in 1952. For those of us old enough to remember, things look a lot like the period between 1973 and 1983 when the CPI touched 15%. Mark Twain is credited with the bon mot: “History doesn’t repeat itself, but it often rhymes.”
High levels of inflation cause enormous problems in a society, and it hurts the poor the most. The average family in the U.S. needs to spend approximately $4,200 more this year than last for the same goods and services, and wages and salaries have not kept up with inflation. To keep up with inflation, employees receive higher nominal wages and salaries, but these incur higher taxes. Moreover, high rates of inflation are an even greater tax on savers — households and companies that maintain cash balances and liquid reserves lose significant purchasing power, as these assets currently yield 1% or less. Inflation also changes and distorts consumers’ behavior, leading them to accelerate their purchases to get ahead of the next price hikes and delaying their repayment of debts and other liabilities in order to pay them with cheapened currencies. Finally, high inflation often causes self- fulfilling prophecies of higher inflation because of the power of this psychology. In brief, high inflation is a blight on society.
The thrust of this investment commentary is to recount and analyze the high inflation period of 1973-1983 in this country and compare it with that being experienced now. How did inflation get so out of control 40 years ago and how was it brought under control? What has caused this current curse of inflation and what is the likelihood that it can be tamed in the coming months and years? Lastly, what does it all mean for the U.S. stock and bond markets, as the Federal Reserve and the administration in Washington wrestle with this unacceptable level of inflation? This is not only an economic problem but a political one, as the elections in November will likely show.
Inflation from 1973 to 1983
As 1972 ended, the CPI was only 3%; twelve months later, it was 9%. By early 1975, the CPI was 12%. It finally peaked in 1980 at 15%. What caused this spike in the CPI after decades of very modest rates of inflation? The initial spike in 1973 and 1974 occurred due to four main factors. The first was that the U.S. went off the gold standard in August 1971, as the U.S. adopted a fiat monetary system, issuing as much currency as was deemed appropriate. Overissuing money is one of the primary causes of high inflation. Secondly, there was the oil shock of 1973-1974 when the price of a barrel of oil rose almost fourfold, as OPEC (led by Arab nations) proclaimed an embargo on oil shipments to countries like the U.S. that had supported Israel in the Yom Kippur War. Thirdly, President Nixon’s administration spent on both guns and butter — the Vietnam War and social welfare policies. Wage and price controls were enacted in 1971-1974 but did little to control prices and instead worked to decrease the supply of food and energy. Finally, an inflationary psychology took hold on consumers and companies, which made inflation worse.
The rate of inflation moderated somewhat from 1976 to 1978, but by the end of 1979, the CPI had reached 13% and increased to 15% by April of the following year. This second jolt of higher inflation was sparked by the 1979 Oil Shock, when the price of oil doubled as production in Iran dropped. This occurred when Ayatollah Khomeini assumed power during the Iranian Revolution. As in 1973, long lines appeared at U.S. gas stations. Wage push inflation also became a major factor, as the cost of goods and services rose, triggered by rising wages. In the late 1970s and early 1980s, both public sector and private economy unions demanded and received multi-year contracts with large wage increases which also led to a continued upward inflationary spiral.
Breaking the Back of Inflation, 1980-1982
Paul Volcker was appointed Chairman of the Federal Reserve Board of Governors in August 1979. Previously he had served as President of the New York Fed and had dissented from Fed policies he regarded as contributing to inflationary expectations. Volcker shifted Fed policy to aggressively target the money supply rather than interest rates. This new policy was meant to signal to the public that the Fed, which had lost credibility in the fight against inflation, was serious about breaking the back of high inflation. He realized that inflation is driven, to a great degree, by expectations of future inflation. The chart below shows the trajectory of inflation and how Volcker’s approach caused the Fed Funds rate to skyrocket to 20% both during the final stages of the Carter administration and in the first years of the Reagan administration.
Forty years later, most people do not understand how difficult this period was for the nation. Many had lost all faith in the soundness of the dollar, and there was a rush into commodities, gold and silver, and hard assets like real estate. The economy went into a recession in mid-1981, which lasted until November 1982. Unemployment rose to 10.9% in late 1982 — the highest level since the Great Depression (higher than the level during the Financial Panic of 2008-2009). The 10-Year U.S. Treasury note was yielding 15% in 1982, with mortgage rates at the same level. The recession and high level of unemployment caused the Republicans to lose 26 House seats in the 1982 midterm elections. But inflation had retreated from a high of 15% in 1980 to 4% by the end of 1982. And, as inflation and interest rates fell in 1982, a secular bull market was launched and ran for 17 years until the collapse of the “internet bubble.” The stock market’s P/E ratio in mid-1982, which languished at 7 (on 12-month trailing earnings), had doubled to 14 by 1986.
Currently, the prices at the gas pump, in the supermarkets, and in restaurants evidence a level of inflation not seen in 40 years. And the price increases relate not just to consumables but include housing prices, rents, airplane tickets, new and used cars, etc. How did we arrive at a CPI of 8.6%? (The so-called “core inflation rate,” which represents the CPI less food and gas prices, registered in May at only 4.7%, but this calculation seems less than helpful, as it removes what most people encounter in prices in their daily life.) In a Wall Street Journal article last month, Fed Chairman Jerome Powell was quoted as saying, “We now understand better how little we understand about inflation.” At BFS, we count ourselves in the Milton Friedman camp, whom we quoted at the start of this commentary as saying that “inflation is always and everywhere a monetary phenomenon …” In fact, in our January 2021 investment commentary on Modern Monetary Theory (MMT), we explicitly warned that a danger of Washington’s apparent embrace of MMT was high inflation. Thus, the cumulative 40%+ increase in the money supply (M2) from $15.5 trillion at the start of the pandemic to $21.6 trillion currently. The chart below shows the percentage growth in the money supply (M2) from $15.5 trillion at the start of the pandemic to $21.6 trillion currently. The chart below shows the percentage growth in the money supply (M2) since the beginning of the pandemic:
In addition to the huge increase in the money supply, the fiscal policy to combat COVID, employed first by the Trump and then the Biden administration, resulted in the government spending over $6 trillion of borrowed money, much of which ended up in consumers’ bank accounts. Many dropped out of the work force, leaving approximately 11 million open jobs currently and only six million unemployed looking for work. The result has been excessive demand chasing too little supply. Exogenous shocks to the global economy like the war in Ukraine producing embargos on Russian oil and food shortages, and the supply chain issues caused by COVID, similar to what occurred in the 1970s with the Yom Kippur War and the Iranian Revolution, have only exacerbated the main issue of too much money chasing too little output of goods and services.
How well has the Federal Reserve dealt with the rising tide of prices? Poorly, in short. As the CPI accelerated from 2% at the start of 2021 to over 5% by June 2021, Fed Chairman Powell and other Fed spokesmen repeatedly called inflation “transitory.” And instead of acting to head off these early signs of inflation, the Fed continued to grow the money supply (M2) at double-digit rates of increase. Throughout 2021 in its program of QE (Quantitative Easing), the Fed bought $120 billion of Treasury securities every month and kept the Fed Funds rate at 0 to .25% all year long. From the start of the pandemic in February 2020 through mid-2022, the Federal Reserve’s balance sheet grew by almost $5 trillion. U.S. Treasury Secretary Janet Yellen recently admitted she was wrong when she commented in 2021 that the risk of higher inflation was “small and manageable.” The chart below demonstrates how far behind the curve the Federal Reserve has been in seeking to curb inflation:
As the chart indicates, the Fed Funds rate is currently almost 7% lower than the CPI. The Fed prefers to gauge inflation using the personal consumption expenditures (PCE) price index, which shows that prices rose 6.4% in May from a year earlier. As can be seen above, the Fed Funds rate is currently approximately 4.5% lower than the PCE index. Moreover, the Fed continued its program of buying bonds until March 2022 as the CPI reached 7%. And it only began its program of QT (Quantitative Tightening) in June this year, allowing $30 billion of Treasury bonds and $17.5 billion of mortgage- backed securities to mature without rolling them over. The Fed has announced that it plans to step up its QT program by allowing $60 billion of Treasury bonds and $35 billion of mortgage-backed securities to mature starting in September. Clearly, the Federal Reserve made an egregious error in ignoring Milton Friedman’s dictum about inflation being primarily a monetary phenomenon. Also, the Biden administration’s fiscal policy apparently did not consider the dangers of an upward inflationary spiral, for in addition to $1.9 trillion spent to combat the pandemic in early 2021 and the projected $1 trillion budget deficit for this fiscal year ending in September 2020, the Build Back Better bill, which was nearly enacted some months ago, would have injected another $1.9 trillion of borrowed money into the economy, adding fuel to the flames.
Where Does the Federal Reserve Go from Here?
It appears as if Fed Chairman Powell and his colleagues have finally gotten serious about inflation. They are coming to the realization that a change in consumer psychology might sustain higher inflation much longer than originally thought. They seem to have finally understood that if households and businesses come to expect high inflation to persist, that mindset will indeed cause actions which make high inflation continue. Thus, at a recent conference in Portugal, Powell indicated that the Fed is determined to act to bring down inflation. He is quoted as saying: “The biggest mistake would be to fail to restore price stability.” In other words, if it takes a recession to restore price stability, so be it. And from recent polls, the biggest issue in the midterm elections which are four months away seems likely to be the administration’s responsibility for the resurgence of high inflation.
In the near term, most pundits expect that the Federal Reserve will raise the Fed Funds rate by 75 basis points at its July 27-28 meeting. This would bring the Fed Funds rate up to 2.25-2.50%. But this would still leave the Fed Funds rate 6% below the CPI. As mentioned above, the Fed Reserve has also announced plans to accelerate QT by letting $95 billion of Treasury bonds and mortgage- backed securities mature without rolling them over in September. However, according to recent Fed minutes, there are expectations that the Fed Funds rate will only need to rise to 3% by the end of 2022 and 3.5-4% by the end of 2023. This prognosis appears to forecast that inflation will fall below 3.5% in 2023. This may be far too sanguine. If consumer psychology has already taken hold, as it appears, the CPI could persist above 5% for some years, in which case the Volcker approach of bringing the Fed Funds several percentage points above the CPI may be needed to curb inflation. That would mean a Fed Funds rate of 6-7%. It would also mean that the yield on the bellwether 10-year U.S. Treasury note would rise to 5% or more — even with an inverted yield curve. This upward trajectory of interest rates, as well as the Fed’s current steps to reduce the growth in the money supply (M2) to almost zero, could well translate into a recession in 2023.
What Does this Mean for the U.S. Capital Markets?
In previous investment commentaries, we have written about the Rule of 20. The Rule of 20 is an approach used to gauge what the proper valuation (P/E – Price/Earnings ratio) of the U.S. stock market should be. Although certainly not precise, it has turned out to have been quite useful over the decades. The Rule of 20 dictates that by subtracting the inflation rate (CPI) from 20, the result should be the stock market’s P/E ratio. The table below shows some data on the Rule of 20 going back to 1973:
As can be seen above, the Rule of 20 has been quite accurate for most periods, but it seems unhelpful currently. The main reason for this is that over the past decade, inflation, as measured by the CPI, has fluctuated until recently between zero and 2%. And investors have focused on the S&P 500’s forward operating earnings rather than on trailing earnings. This has had the effect of elevating the P/E ratio on trailing earnings, as can be seen by the P/E on June 30 of this year. Using current estimates of the S&P 500’s forward 12-month operating earnings of $230, the P/E, with the S&P 500 now trading around 3,900, is approximately 17. If inflation does fall to around 3-4% in 2023, as the Fed predicts, then a P/E ratio of 16 or 17 would result in a market level close to its current level. However, if inflation persists at 5% or even higher, the stock market’s valuation now seems elevated and even rich. The Rule of 20 would call for a P/E ratio of around 15, which would mean a further drop of 10-15% in the S&P 500 this year.
If the 1970s/1980s are to be repeated in the next several years, we think it is likely that interest rates will need to be elevated well above 4% to successfully combat inflation. This would cause bond prices to continue falling. This is especially true of long-duration bonds. Accordingly, at Bradley, Foster & Sargent, we are using very short-duration fixed income instruments in case inflation is not easily tamed.
Based on the Fed’s newfound determination to bring price stability and the measures that will be necessary to make this happen, we believe that the chances of recession in 2023 are greater than 50%. A recession would cause the operating earnings of the S&P 500 to fall 25% or more from $230 to perhaps $170. The combination of higher interest rates and a recession would presumably bring the CPI down to approximately 3% or lower. Using the Rule of 20, this would translate into an S&P 500 trading at around 2900 — a P/E of 17 x earnings of $170 — a 40% drop from the market peak in January 2022. While we do not believe that it is possible to accurately forecast a market bottom (nor a recession for that matter), we do believe that we are still in a period which calls for a thoughtful, defensive approach to the stock market. For growth accounts with a long runway until funds are needed, we would recommend continuing to own great companies for the long haul and looking to buy at cheaper prices stocks in companies that are likely to compound earnings at attractive levels for the years ahead. But for investors whose asset allocation is focused more on capital preservation and the distribution of income, we believe that maintaining some dry powder to purchase stocks of quality companies at even better prices, until the Fed has demonstrated that it will do what it takes to curb inflation, makes good sense.
Rob serves as chairman of Bradley, Foster & Sargent. He is a portfolio manager and member of the firm’s investment committee and its board of directors.
Rob founded Bradley, Foster & Sargent with Joseph D. Sargent and Timothy H. Foster. Earlier, he was president and CEO of Boston Private Bank & Trust Company, which he founded in 1985, and he spent 14 years with Citicorp, including 12 years in Europe, the Middle East, and Africa. Previously, he served as an officer in the U.S. Navy in Vietnam.
Rob served for seven years on the board of governors of the Investment Adviser Association, the national not-for-profit association founded in 1937 that exclusively represents the interests of federally registered investment advisory firms.
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