Long ReadMar 16 2022

Inflation: (not) that 70s show

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Inflation: (not) that 70s show
Credit: Unsplash

For two decades prior to 2000, inflation would occasionally spike, mostly due to energy disruptions, but overall price rises would be increasingly moderate.

After the turn of the century, when China took its place as the world’s appointed manufacturer, that trend accelerated. China would import growth and technology and export deflation, in the form of cheap manufactured products.

The 2008 global financial crisis happened, and global central banks printed nearly $18tn (£13.7tn) of new money. To everyone’s surprise, prices remained the same and inflation’s death certificate was issued in absentia.  

And then, 2021 came. Prices began to rise at the fastest pace in nearly half a century. Central banks spent two quarters in denial and then made an about-turn at the end of the year, scrambling to get ahead of the curve before it was too late. As policymakers lost their calm, markets soon followed.

Investment managers, a lot of whom have never really experienced inflation, are now scrambling to find historical paradigms that could provide a guide for the future. 

None has served so well as the 1970s, a dismal decade in global economic history. In the UK, from 1969 to 1982 prices rose 12.5 per cent every year on average. Evidence shows that inflation has not climbed as fast as it does today since 1979. 

The period was characterised by economic stress, a flood of fiat money and persistent geopolitical instability, all of which fuelled inflation to a boiling point.

Substitute Ukraine for Israel (Yom Kippur War) and one gets a seemingly perfect fit. The war comes on the back of already quickly accelerating prices because of pandemic-related supply chain disruptions. Sanctioning Russian raw materials exports on top of present pressures makes runaway inflation a real risk.

Where will it stop?  

The number that stands out is 26.5 per cent. This is the historic highpoint of the UK RPI, registered in August 1975, a few months after British coal miners accepted a 35 per cent raise from the government. In that year alone, households saw a quarter of their savings evaporate because of inflation.

However, we do not necessarily favour the historical approach. Drawing parallels between the 1970s and the present might help a history PhD candidate attain a degree, but it would probably ill-serve those whose decisions have tangible and not theoretical consequences. Investors and economists, whose conclusions may affect policy or individual wealth should probably avoid the industry’s obsession with all things past.

This is not the 1970s all over again

For one, the underbelly of inflation is different. In 1971, Richard Nixon had rejected the gold standard and global economies entered the era of monetarism and fiat currencies. Inflation, in hindsight, was a normal consequence. Conversely, the world up until a year ago was characterised by secular stagnation, a consumer propensity to save rather than spend, which is deflationary in nature. We have no evidence that this has changed. 

The measures of inflation are also very different. In the 1970s, the inflation basket was mostly comprised of household goods. Today, services comprise a much bigger portion of our spending. 

Also, central banks are much more equipped now with multiple tools other than headline interest rates. They have strong inflation mandates and, in theory at least, independence to act. The current model of central banks has often been cited as the reason that inflation was fought off in the 1980s. 

Then there is the velocity of price rises. Sure, we have not seen anything like the speed at which commodities rose for nearly 50 years, but back then demand and supply were mostly industrial. Today, the derivatives market is enormous, cash to lever is cheap and speculation runs rampant. Prices can fall as easily as they rose, if the ‘fast’ money decides there is no real reason to pay for contracts to ‘roll’ for a long time.  

And of course there is unemployment to consider. The 1970s featured slow growth and higher unemployment. Today, unemployment is very low and labour participation rates are below pre-pandemic lows in the UK and the US. As the pandemic passes, those who had to stay at home may yet again join the labour force and ease wage inflation pressures. In the UK the situation is slightly more perplexed, of course, because of Brexit, but there are still plenty of Britons who abstain from employment due to Covid-related issues. 

Additionally, there is China and the global supply chain. While China’s turn to its internal market is definitely inflationary, the country still produces a lot of cheap goods for the world. So do many other emerging economies, all served by global supply chains. We think that modern logistics is powerful and can be counted upon to efficiently get goods from point A to point B when initial shocks have passed. Case in point, UK exports to the EU are currently above pre-Brexit levels.

Finally, we cannot ignore the biggest difference of all: the ‘green drive’. In the 1970s, addiction to oil was a powerful geopolitical force. Today, the world is determined to wean itself off fossil fuels altogether. The longer oil prices remain very high, the more money will be diverted towards finding alternatives and the quicker a fossil-free future becomes attainable. Investors are getting more interested in fusion, green hydrogen and ways to reduce the life of nuclear waste by the day.  

We cannot be certain where inflation will peak, but, given its current impetus, we would not be surprised if it crossed the 10 per cent threshold. However, the peak is of little consequence compared to duration.

The 1970s featured a whole decade of inflation. We feel that it may not be as persistent this time around. Instead of intuitively aiming at a peak, we would look further into the future. We believe that inflation will eventually subside, however at levels higher than the pre-pandemic 1.5 per cent to 2 per cent. The confluence of China’s transition to the tertiary economy and the global transition to green energy may well bring long-term inflation higher, at 2 per cent to 3 per cent. This is the real number economists, policymakers and asset allocators should be considering for their long-term approach.

George Lagarias is chief economist at Mazars