The recent WSJ article by James Mackintosh1 “Everything Screams Inflation”, breathlessly tells the financial world that we are at a “generational turning point” and “investors are woefully unprepared”. A Telegraph article also declared that “The Fed QE Will Cause Inflation This Time”. All of this echoes an avalanche of media and advisory reports in recent months calling for much higher inflation ahead.
Alpine Macro has been trying to address this fear in quite a few research reports. I would like to take a look at the 1970s inflation experience, which no doubt is the “generational turning point” referred to by the WSJ. I remember that episode well, having worked at the Bank of Canada in the 1960s, when the groundwork for the 1970s inflation was laid.
My Brief U.K. Stint In The 1970s
In the early to mid-1970s, when inflation began to soar, I was living in London, having moved the then-small BCA there for a while, to get a ring-side seat to observe what a real inflation looks like. As it turned out, the 1970s saw the greatest peace time inflation. I was not disappointed with the learning experience: The U.K. stock market halved and then halved again; my floating rate mortgage on 100% of my new home moved in six months from 8% to 18%. Sterling collapsed (Chart 1), gold was soaring, coal miners went on strike, reducing power supplies and forcing the economy onto a three-day week. Out-of-work Cockney traders in the city started calling an over-the-counter market in toilet paper!
It was already getting scary but when the OPEC oil embargo ran the oil price up in its first of two big moves from $4 to about $10/bbl (Chart 2), it created a huge shortage of gasoline, diesel and jet fuel, and reinforced the already severe shortage of energy from the coal miners strike. Conditions went from being scary to frightening. The oil price later had a second big move to $40/bbl, a 10 bagger for OPEC and a disaster for oil consuming countries.
America’s Inflation Problem Back Then
From 1965 to 1980, U.S. price inflation moved in three major waves from below 2% to a peak of over 14% in 1980 (Chart 2, middle panel). It is important to note that the 1970s inflation was not a surprise. It had reached over 6% in the late 1960s before pulling back after the brief 1970-71 recession. The reason for that 1965-1970 surge was that President Johnson, in the second half of the 1960s, pursued a “guns and butter” policy – fighting an escalating war in Vietnam and another domestic one on poverty, racism and inequality. That was labelled the “Great Society” program and rivalled Roosevelt’s “New Deal” of the 1930s.
The problem was that there was no slack in the economy. In fact, the economy was running on average about 2% above capacity. There was a brief respite during the shallow and brief 1970-71 recession but then the economy roared back and moved 4% above capacity. Inflationary pressures started building rapidly again, having been cooled only temporarily. Under the surface, inflationary pressure was very much alive and well.
The breakdown of the Bretton Woods System in March 1971 was another major structural reason behind high and rising inflation in the 1970s. Since the end of the WWII, the U.S. was on a quasi-gold standard.3 However, the gold standard was misunderstood. It was frequently a fair-weather standard. If a country does not follow the rules because it doesn’t like the discipline imposed, it loses its primary function of maintaining price stability.
Chart 3 shows U.S. gold reserves from 1960 forward. The early stage of the decline in gold reserves reflected a post-war rebalancing of central bank gold reserves but after 1965 when inflationary pressure accelerated, the decline in the gold stock steepened, interrupted only briefly during the 1970-71 recession. This was the classic warning signal from the gold standard: time to tighten monetary policy. By August 1971, the U.S. had to make a decision – deflate to maintain the gold/ dollar link or let the dollar float and escape from the discipline. With the major shift to the left in politics and high unemployment, there was no appetite to deflate. President Nixon opted for delinking the dollar from gold.
The dollar price of gold moved rapidly from $35/oz to $180/oz and the trade-weighted dollar fell in its first phase by about 10%. Inflation soared as prices for anything that was priced off the dollar took off.
As I mentioned earlier, oil prices more than doubled in 1970 and more than doubled again in the late 1970s. The U.S. economy was much more oriented toward manufacturing than today so surging crude prices shook the economy very badly. That was when the term “stagflation” was coined, describing a stagnating economy but with high inflation.
The Fed was terrified to let this relative price shock get absorbed by the real economy, so they mone-tized it through much of the 1970s, causing the U.S. dollar to decline much further, both against gold and on a trade-weighted basis. The inflationary surge ended in 1981 with Paul Volcker’s “cold bath” policy which included 20% interest rates at the peak.
当年美联储害怕让这种相对价格冲击被实体经济吸收，因此他们在20世纪70年代的大部分时间里将其货币化，导致美元兑黄金和贸易加权汇率的进一步下跌。1981年，随着保罗沃尔克（paulvolcker）推行的“冷水浴”（cold bath）政策，通胀率飙升结束，20% 的利率水平也见顶回落。
Where Monetarists Have Been Wrong
A major lesson for me from that experience in 1973-74, and the rest of the decade back home later, was to make me hyper-sensitive to inflation and it took me a long time to stop seeing another major inflation outbreak every time the Fed became expansionary, and the Treasury ran bigger deficits. The reality was that, after Paul Volcker gave the economy a cold bath in 1981 and President Ronald Reagan focused on the supply side of the economy in the 1980s, price inflation has been on an irregular path downwards from the 14% peak in 1980 to the (temporary) near-zero reached in April 2020.
这个十年剩下的时间里我回到了国内，1973-1974年的经历给我上了重要的一课，那就是让我对通胀非常敏感，每次美联储扩张，财政部赤字增加，我都花了很长时间仔细思考另一场大的通胀是否会爆发。现实情况是，在1981年保罗·沃尔克（Paul Volcker）给经济洗了个冷水澡，上世纪80年代罗纳德·里根（Ronald Reagan）把重点放在经济的供给方面之后，通胀率就一直在不规则地从1980年14% 的峰值下降到2020年4月（暂时的）接近零的水平。
During much of the 1980s, the money supply (MZM) rose strongly (Chart 4). Milton Friedman’s monetarist model was still in vogue. Inflation fears remained endemic throughout the 1980s. However, the model was deeply flawed because the velocity of money has come down steadily since Volcker’s time, absorbing much of the growth in money supply.
This is a lesson for all forecasters who rigidly adhere to an outmoded theory. Like everything in economics, you have to look at both demand and supply. In the 1980s, the demand for money soared, a phenomenon then called “monetary re-entry.” Only later on did people realize that velocity of money is simply a function of interest rates and has, therefore, collapsed along with falling price inflation. A slowing velocity has absorbed much money creation, preventing price inflation from sustainably rising. That should be remembered in the context of today’s inflation fears.
Most people’s mental framework goes back only as far as their own memories and experience and creates a subconscious bias. The 1960-80 period was structurally totally different from today’s. Very few investors, economists, journalists and policy makers today were working then. Some salient differences between then and now are worth noting.
(1) The U.S. was essentially a closed economy in the 1970s. Imports were about 3.5% of GDP. They are now almost four times larger relative to GDP (Chart 5). Imports are a big safety valve; when shortages arise and prices rise, imports increase to take the steam off. That doesn’t happen easily in a closed economy. In addition, there has been a relative abundance of excess savings in the rest of the world. This means that the U.S. can easily import much cheaper foreign savings to make up any shortfall in domestic savings, should the economy run too hot.
(2) Manufacturing then was almost a quarter of the economy; it is 10% now. The world currently is well into the “Fourth Industrial Revolution”, dominated by both technology producers and users, and a perfect storm of technological innovation is occurring and will accelerate in the years ahead. The rapid digitization of the world economy, robotic technology, AI and 5G communication are inherently deflationary which goes a long way towards explaining why the Fed has not been able to get inflation up to its target for more than a decade (Chart 6).
(3) Unionized workers then were 25% of the labor force, now they are about 10%. Labor unions introduce wage rigidity, while reducing labor productivity (Chart 7). In the 1970s and 1980s, wage rigidity was a key reason causing wage-price spiral. Most workers in the U.S. today not only have to compete for jobs among themselves, but also, directly or indirectly, have to compete with workers in low-wage countries as a result of globalization. It is very hard for the average wage rate to sustainably exceed labor productivity.
The burning question today is whether another major inflationary surge could happen again? My take is that it is possible but very unlikely. Slack in the economy is still substantial, estimated at roughly 2.3% of GDP, in contrast to significant excess demand for much of the 1960s and 1970s.
Some would argue that the Fed’s monetization during the two oil shocks in the 1970s greatly exacerbated the inflation outbreak and the Fed is monetizing fiscal deficits today. What’s the difference? In my view, the comparison is not entirely correct: Back in the 1970s, the U.S. economy was running above potential, so the Fed eased into a booming economy with no spare capacity. Since 2020, however, the Fed has been easing aggressively on a collapsing economy with unemployment shooting up to 15%. Even today, the U.S. still has 8 million people out of a job. Of course, if the Fed continues this policy long after the economy has fully recovered, that would be inflationary, but it is too early to make that judgment at the moment.
How about fiscal stimulus? A lot of the fiscal thrust with current policy is in the form of transfer payments and has nothing like the demand impact of government expenditure in goods and services via investment. In addition, these transfer payments will reverse in good part in the year ahead. President Biden's infrastructure proposals will get scaled back as will the tax hike proposals. It is hard to believe that the Fed would remain aggressively expansionary once inflation is moving back to where they are aiming.
With the dramatic reduction in the U.S. economy's oil intensity (Chart 8), there cannot be a major oil shock like the 1970s. If anything, the oil price is likely to reinforce deflationary pressures as the decarbonization of the economy proceeds and technology continues to reduce the cost of green alternatives. The mania in anything green means that access to capital is seemingly unlimited and this has to increase the supply of energy alternatives.
题图来自 Pexels，基于 CC0 协议