These days, many of us look back at the 1970s with an eye toward nostalgia. The decade is now fondly remembered for great music, the Golden Age of television, Studio 54, and in many ways, a simpler time where a middle class still thrived. Of course, we forget about social unrest, violence, Watergate, the losing end to our war in Vietnam, and inflation.
Many Americans either weren’t born or are too young to remember what a great problem inflation was during the 1970s. The scourge of inflation had gotten so bad that the Federal Reserve itself seemed to be, until 1979, powerless to stop it. Meanwhile, the federal government launched perhaps one of the silliest solutions to a serious problem ever when they came out with WIN buttons (“Whip Inflation Now”) for everyone to wear.
The history of the late 1960s and 1970s tells us that financial markets do not respond well to persistent inflation. During this period, interest rates stayed stubbornly high and stocks were more or less in a bear market. So how did the United States—the symbol of economic power and stability in the post-war era—fall into such a precarious condition?
When people studied economics back in the 1970s and 1980s, there was a popular question as to whether an economy could sustain higher military spending (“guns”) and higher societal spending (“butter”) at the same time and not exhaust the economy’s limited resources and thus, cause inflation wherein “too much money chased too few goods.” In the 1960s and early 1970s, the United States decided to test this theory out and, sure enough, the theory was right!
A sharp increase in government spending on the Vietnam War and “The Great Society” was embarked upon, and, combined with the Federal Reserve’s easy-money policy, inflation was driven to levels not seen since the end of World War II. As inflation rose, the U.S. Dollar came under tremendous pressure, to the point where President Richard Nixon effectively ended the post-war Bretton Woods fixed exchange rate regime in 1971, which only spurred on more inflation.
Finally, the two oil shocks in 1973 and 1979 were the cappers. In 1979, President of the New York Fed, Paul Volcker, was appointed by President Carter as Federal Reserve Chairman and the rest is history. Chairman Volcker embarked upon super-tight monetary policy to finally slay inflation. While most think, in hindsight, that the draconian policy shift was necessary, the policy resulted in two deep and painful economic recessions.
Now, more than four decades later, we are probably having our first serious discussions about whether the risk of corrosive inflation has returned. In the past few months, raw materials, industrial metals, agricultural, and energy prices have increased sharply, with commodities such as lumber and copper setting new all-time highs. The question presented to investors and the Fed is, are these price rises transitory—the effect of the economy breaking out from a dead stop, spurred on by massive fiscal spending—or is it something larger?
Notable investors such as Jeff Gundlach from Doubleline Capital, believe that these pressures are not temporary, that inflation is already here. Additionally, many global corporations remarked on the rise in costs of production and their plan to pass them on to consumers in their earnings calls last week. From the Financial Times:
Nestlé, Procter & Gamble, and Unilever are among the global groups to have set out plans for price rises in their latest market updates following commodity price jumps and a spike in transport and packaging costs. “We are seeing some of the highest commodity price inflation that we’ve seen in a decade,” Graeme Pitkethly, chief financial officer at Unilever, told reporters this week. Mark Schneider, chief executive of Nestlé, said last week: “This is a very volatile environment right now, very low visibility, lots of surprises happening. We will take pricing action.”
However, the Federal Reserve disagrees with Gundlach. Last Wednesday, the Federal Reserve concluded its latest FOMC meeting with a clear message that it will let the economy “run hot” in the face of inflationary pressures for the foreseeable future. Chairman Powell reiterated his belief that the inflation will be transitory, the result of the economy going from standing still to trying to run. Commodity shortages and supply-chain bottlenecks will get sorted out relatively soon. Additionally, concerning inflation, Chairman Powell had a very interesting comment when he appeared on the television show “60 Minutes” in April:
“In addition, though, the economy has changed because the globalization of the economy and technology have enabled manufacturing to take place all around the world. It's very hard for people in wealthy countries to raise prices or to raise wages. It's hard for workers to raise wages when wages can move overseas. So, it's just a different economy. And one manifestation of it, if you look around the world in other wealthy countries, they're all experiencing very low inflation and really have for the last quarter of a century.”
What Powell said is very telling. The biggest variable in the price of goods and services remains the cost of labor. It was “globalization,” achieved by such free-trade deals like NAFTA, which sent millions of jobs overseas without any real focus on replacing those jobs or addressing the lives of those Americans who lost those jobs. This, in turn, created our yawning wealth gap and powered financial assets to greater and greater heights, to some extent, at the expense of the dispossessed working class. Globalization, or shipping jobs and production to cheaper labor markets with non-existent labor and environmental regulations, probably did more to stamp out persistent inflation than the draconian monetary policies of the Paul Volcker Federal Reserve in the late 1970s and early 1980s. Labor lost its power to be a price maker, and, in line with what Chairman Powell said, became a price taker.
Uncertainty over a phenomenon that we really have not seen in at least four decades is returning. What happens to the financial markets if the Fed is wrong and there is a sharp and lasting inflationary shock? What happens if the specter of inflation gets into the societal psyche? Do workers regain the pricing power that they once had to push to keep wages higher with inflation, creating the spiral that drives inflation even higher?
History has shown us that persistently high levels of inflation tend to punish financial assets perhaps more than any other factor. It is often said that tighter monetary policy during an economic expansion is akin to the Fed taking the punch bowl away before the party really gets started. Taking the punch bowl away early has usually helped save the value of financial assets over time while putting the greatest losses on those who do not have those assets.
Therefore, the Federal Reserve will have to reckon with a very tough question of which is more important? Should the Fed keep the economy running hot to help the majority of Americans who do not own substantial financial assets? On the other hand, should the Fed intervene with monetary policy if inflation readings continue to rise to protect the long-term health of stocks, bonds, and other financial assets? The Powell Federal Reserve currently seems to be leaning towards leaving the punchbowl be. If they are wrong, there will be very serious financial market consequences.
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