Are we in for a 1970’s style inflation revival?

When Fed Chair Jerome Powell spoke at a moderated Q&A last Tuesday, he confirmed the higher-for-longer message of virtually all other Fed speakers: “The recent data have clearly not given us greater confidence and instead indicate that it is likely to take longer than expected to achieve that confidence [to reduce rates]”.

As a consequence of the shift to a higher-for-longer narrative, different versions of this ominous CPI chart have been making the rounds. Could we be in for a 1970s-style inflation revival?

To answer that question, investors need to grapple with the problem that economists don’t have a good unifying theory of what causes inflation.

Let’s start with the Austrian school of economics that runaway fiscal deficits cause inflation. As the accompanying chart shows, core CPI (black line) was creeping upwards in the 1960s and got out of hand in the 1970s. If fiscal deficits were sparking inflation, why was the debt to GDP ratio (blue line) declining for much of that period?

Another popular explanation is Milton Friedman’s monetary theory that inflation is a monetary phenomenon. Excessive money growth causes inflation. In that case, why was CPI in a prolonged downtrend in the 1980’s and 1990’s despite the strong growth in M2 money supply (red line) for much of the 1980’s?
 

 

 

Key differences

Here are some key differences between today and the 1970s era of runaway inflation.
In the 1970s, the Fed allowed inflationary expectations to run out of control. That’s not the case today. Even though the breakeven rate has edged up a little, market-based measures of inflationary expectations are well-anchored. To be sure, levels are slightly above the Fed’s 2% target, but readings don’t show any signs of acceleration.

 

Rising inflationary expectations led to a cycle of both cost-push and demand-pull inflation. Fed Chair Paul Volcker broke the cycle with a painful regime of high interest rates (red line) that tamed rising price expectations and wage increases (blue line).

Today, the good news is the Atlanta Fed’s wage growth tracker shows that increases are decelerating at an annual rate of 4.7%. The bad news is the readings are well above the Fed’s 2% target.

 

When we consider the inflation picture today, core PCE is falling, but core services is stubbornly high.
 

 

Further analysis shows that shelter and transportation costs are the key drivers of inflation in 2024. As BLS shelter inflation indicators operate with a lag, it is also known that real-time estimates of rent and shelter inflation are falling rapidly.
 

 

If the investment narrative today is “higher for longer”, the longer-term view is “longer doesn’t mean forever”. Rate cuts will eventually be necessary. Indeed, the market is now discounting the first Fed cut to occur at the September FOMC meeting.
 

 

An era of fiscal dominance

That said, we live in an era of fiscal dominance, or high fiscal deficits. The IMF recently issued a warning about the sustainability of fiscal deficits in the U.S. and China.
 

 

As the U.S. is undergoing an election this year, the IMF observed that spending tends to be more expansionary in election years, which worsens the deficit.
 

 

Lisa Abramowicz at Bloomberg reported that Morgan Stanley expects greater fiscal deficits regardless of whether the Democrats or Republicans win the election, though each party will plot its own fiscal path. That sounds about right.
 

 

The problem remains the U.S. will need to refinance about 40% of its total debt of $34.5 trillion in the next three years. However, the problem doesn’t appear to be dire. The IMF is projecting U.S. interest payments will be stable as a percentage of GDP out to 2029.
 

 

 

A matter of expectations

In effect, rising yields would put considerable strain on the federal budget. Much depends on the bond market’s expectations of inflation and interest rates.

For investors, the evolution of risk appetite will depend on changes in term premium, or the yield compensation the market expects for holding a long-dated bond. Rising long-term inflationary expectations translate into a higher term premium and higher bond yields.

So far, term premium has been edging up, which creates a headwind for stock prices and other risk assets. Tactically, the coming week’s heavy Treasury auction may provide some clues to risk appetite. The U.S. Treasury is selling $69 billion of 2-year notes, $70 billion of 5-year notes, $44 billion of 7-year notes and $30 billion of 2-year floating rate notes for a total of $213 billion. In addition, keep an eye on the market reaction to the Quarterly Refunding Announcement (QRA), due on April 29 and May 1, as a gauge of appetite for Treasuries.
 

 

In conclusion, fears of a repeat of the 1970s inflation cycle are overblown. Inflationary expectations are well anchored and the pace wage increases are decelerating. However, the IMF has warned of the risks of the deteriorating U.S. fiscal picture and investors have to acknowledge that we are in an age of fiscal dominance.

For investors, the evolution of risk appetite will depend on changes in inflationary expectations and term premium.