In the aftermath of 2008’s Great Financial Crisis, interest rates were cut to unprecedented low and negative levels. At the time, many questioned whether this would inevitably lead to high inflation in the short or medium term. However, to the surprise of many economists, the level and volatility of inflation rates seemed to defy gravity for over a decade. As a result, investors, analysts, and other market participants scaled back the magnitude and frequency of low probability risk events in their models. This was a mistake.
In hindsight, the failure to properly account for these events can be best explained as an example of recency bias, or the overemphasis of recent events and information, and a flawed belief that long-term financial history is not relevant to today’s situation.
The period of relatively low inflation volatility between 1997 and 2021 that caused myopia among market participants is quite the outlier when compared to the longer historical record. Throughout the last century, prolonged periods of higher inflation have been a recurring feature.
In recent months, students of financial history have compared the recent surge in inflation to the 1970s inflationary environment before Paul Volcker stepped in as chairman of the Federal Reserve in 1979. Although superficially correct, this is still shortsighted. Often, we reach for the most recent historical period as a reference point when the best comparison is actually further back in time.
The inflation of today structurally has little to do with what was experienced in the 1970s. As we have seen, inflation during that period was spurred on by poor central bank monetary policy which relied on the flawed concept that persistently low unemployment could be achieved with only moderately high inflation, which is a key facet of the economic model we refer to as the Phillips Curve. At the time, central bankers used this model and its assumption to try and stabilize the macroeconomic environment.
There were many other factors at play during this time, including the large stocks of the US Dollar that many countries were forced to hold due to Bretton Woods. This led to an oversupply of capital which could not be reined in by a constrained Federal Reserve. These factors are less relevant today, when we have a comparatively well-ordered monetary policy, relatively independent central banks, and free currency markets.
Our current inflation episode is much more complex, driven by a supply-and-demand imbalance with diverse root causes. A closer analysis shows that instead of the 1970s, the post-WWII inflationary episode, 1946 to 1948, is likely a more appropriate corollary to the current situation.
In 1946, the real economy was characterized by supply shortages due to manufacturing disruptions during peace-time retooling, pent-up demand for consumer goods, high levels of savings, the cessation of rationing and price controls, increased government spending, and a soaring supply of money. The similarities to the post-Covid, post-Ukraine world are clear.
In the case of our current inflationary episode, much of the government spending was absorbed, canceling out the damage done by the pandemic and its subsequent lockdowns and restriction of movement. One of the more interesting aspects to consider is an explosion in savings. During the Covid pandemic, like the post-WWII period, there was a rapid increase in total money supply. Lockdowns around the globe constrained consumers’ ability to spend money considerably, resulting in a glut of savings and liquid assets. According to the Federal Reserve’s estimate, the “M2 supply”, which includes cash assets and money deposited in checking accounts, savings accounts, and other short-term saving vehicles such as certificates of deposit, increased by 24.8 per cent between December 2019 and December 2020. In comparison, the magnitude of increases in the 1970s is muted.
In the post-war period, supply and demand ultimately came back into balance, but the path back to normal inflation levels was not smooth. Only after nearly three years of high inflation in the US, the inflation rate fell rapidly from its peak in March 1947. Just over a year later, it spiked nearly three percentage points, until eventually it subsided. Even after inflation began its downward trajectory, it still intermittently spiked upwards before succumbing to outright deflation in 1949 and 1950 – a fact that is likely not lost on central banks today who try to navigate a delicate balancing act of securing a “soft landing.”
By looking back to the 1940s inflation episode, the lessons we learned then may help us to understand the path by which inflation might evolve over the coming months and quarters: then, market forces worked as they should, and time was the ultimate healer. The post-WWII period ended with consumer demand for goods and services naturally subsiding, supply coming into equilibrium, and production and manufacturing capacity reordering as the world transitioned into peacetime.
As market participants across the investible universe suffer from high inflation and therefore lower real rates of return, economists seeking stability would do well to expand their memory and look beyond just the previous five decades. As Ronald Reagan was once quoted as saying, “Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hit man."
