A '70s-like second inflation wave is still unlikely

Some market observers have likened the fast rise and collapse in consumer price inflation since the end of the Covid pandemic to the situation in the '70s and warned that the first inflationary period back then was followed by an even more brutal second wave. The idea that current benign price rises represent only the calm before another storm was recently fueled further by an uptick in the U.S. headline CPI. This ignores the substantial differences between the '70s and today's economic environment.

When the consumer price index began to surge to levels not seen in decades in 2021 and 2022, it naturally evoked memories of the great inflationary phase of the '70s and early '80s and its frightening consequences on financial markets, the real economy, and society. Former FED-char, Janet Yellen recalled her own memories in an interview, saying "I came of age and studied economics in the 1970s and I remember what that terrible period was like". However, the number of market participants and policymakers who still possess first-hand memories of this time 50 years back is declining quickly, and even those old enough to have experienced it may not remember the circumstances in detail. We, therefore, dug a bit deeper into the topic to summarize what really drove the double wave in inflation and how the situation today may or may not resemble it.

Our research draws heavily on "The Anatomy of Double-Digit Inflation in the 1970s" by Alan S. Blinder, a chapter in a 1982 NBER working paper on the causes and effects of inflation. Beyond this, we have studied various historical time series published by the US Bureau of Labor Statistics and run empirical comparisons between the dynamics and weights of critical CPI components during the '70s and early '80s and today.

The first wave 1972-1974

As emphasized by Blinder 1982 and depicted in the graphic above, the first wave of inflation experienced in the early '70s was initiated by fast-rising food prices caused by poor weather conditions in the US and much of the rest of the world. This sudden burst took policymakers by surprise not least because, unlike earlier periods, the 1950s and 1960s experienced unusually low swings in food prices.

The food price shock and its second-round effects through accelerated wage growth are estimated to have lifted inflation by around 5% in the early 1970s. Food price inflation by itself thus caused a worrying CPI increase but was subsequently exacerbated by an energy shock induced by the solidification of the Organization of Petroleum Exporting Countries (OPEC) in the wake of the Arab-Israeli conflict in October 1973. The latter led to a fourfold increase in crude prices and, according to various estimates, contributed between 3% and 4.5% to headline inflation between 1974 and 1976.

It is worth noting in this context that in 1970 and thus before the shock, food commanded a 22% weight in the US headline CPI, compared to only 14.4% in 2022.
As during previous episodes in the 40s, food inflation declined quickly towards the midst of the '70s, thus naturally bringing down headline prints. Likewise, while oil prices continued to inch higher in 1975, 1976, and 1977, year-on-year increases were more benign, thus limiting its impact on inflation rates.
Lastly, artificial price controls, often overlooked retrospectively, were another aspect of the '70s inflation period. In an unprecedented peacetime experiment, the Nixon government selectively froze prices and wages between 1971 and 1974.

According to Blinder, this experiment had little effect on average inflation levels. Still, it shifted the timing of its occurrence reducing inflation in 1972, when it would have been relatively low anyway while fueling it further in 1974 when prices increased fast and controls were lifted. This aspect is interesting as it explains the sudden outburst in core inflation between March 1973 and February 1975. It also represents a cautionary tale for anybody attempting to run historical comparisons without considering all non-quantitative aspects. In the early '70s, unlike today, core inflation excluding food and energy eventually reached the same level as headline inflation. Still, as shown in the figure above, we can easily observe the substantial lag caused by government intervention.

The second wave 1972-1974

Food price inflation hit a low at close to 0% in December 1976, before rebounding to more than 7% in 1977 and peaking at over 13% in 1979. This second food shock may look similar to the former at first sight but its origins were markedly different. As Blinder outlined, 1975 marked the beginning of an unprecedented double-digit decrease in the size of cattle herds as a reaction to low prices for beef products at the producer levels. During the height of the crisis, frustrated farmers turned to slaughtering calves in front of television cameras. Only in 1979 did farmers finally begin rebuilding their stock.

At the same time, pork and poultry production, initially offsetting the decline in beef production was hurt by harsh weather conditions, diseases, and regulatory uncertainty during the winter of 1977 and 1978. Consequently, food price inflation surged again, mostly driven by meat prices. Nevertheless, unlike during the first wave, food's contribution to overall inflation was eclipsed by a sharp rise in energy prices as crude jumped from 15 USD in 1979 to almost 40 USD in 1980.

This energy price shock was sparked by the Iranian revolution in January and February 1979 that rapidly disrupted supply chains resulting in a surge in spot-market prices and eventually culminating in long queues at gasoline stations in the summer of 1979. The shortage, alongside the increased wallet share of oil after 1973, meant that the price surge in the commodity market hit consumers faster and heftier than the first energy shock in the early '70s. Furthermore, it levied a much more significant toll on the economy. Blinder 1982 estimated that the second energy price shock was worth 6.5% of U.S. GDP, compared to only 2.5% of the former. It is thus not overly surprising that economic activity declined in the wake of this shock sending unemployment rates to 11% in the early '80s and explaining Yellen's bad memories of the time.

As outlined in the Figure above, the Fed reacted quickly to the inflationary pressures of the early '70s. Still, it was equally fast at lowering rates again when the immediate danger appeared to be over. The approach to inflation-fighting shifted during the second bulk when the Volcker Fed was determined to crush inflation once and for all, even facing double-digit unemployment.

Perversely, higher rates, provoked by inflation, hurt the CPI as elevated mortgage rates drove up the cost of shelter in 1980, resulting in a 3.7% difference between the CPI and the CPI adjusted for mortgage interest payments shown during the first half of the year and representing approximately one-third of the total acceleration from 1977 to 1978. When drawing lines between the '70s and today's inflation, investors are advised to pay close attention to this factor.
Before 1983, the Shelter CPI was based on housing prices, mortgage rates, property taxes, insurance, and maintenance costs, creating the observed link between monetary policy and the CPI that Blinder 1982 called a "serious measurement problem".

The methodology was, therefore, abandoned following the experience of the early '80s and replaced with the current "rental equivalent" approach that measures inflation based on rents (7.5% weight in 2022) and owners' equivalent rent (24% weight in 2022) that is derived from a subset of the same rental data and, therefore, tends to be highly correlated. Consequently, the shelter component in the CPI became significantly less volatile and decoupled from short-term changes in interest rates as shown in the chart below.

Where we stand today

Unlike in the '70s and 80's, policymakers, not anticipating China's prolonged lockdowns and Russia's attack on Ukraine, were slow to react this time but will certainly try to avoid the mistake of easing too early.
In this context, the data in the figure above reminds us of the uncomfortably high and only slowly declining level of rent inflation today. Shelter inflation hit 8.8% in March 2023 and still stood at 8% in July. Consequently, rising housing cost was responsible for the bulk of aggregate price rises in recent months. Excluding this component, core inflation would have declined to around 3%. While the new methodology adopted by the Bureau of Labor Statistics in 1983 implies that interest rate hikes don't directly translate into shelter inflation anymore, there may be indirect second-round effects as the tightening in 2022 went hand in hand with a notable decline in construction activity. Interestingly, building permits climbed to their highest level since the Great Financial Crisis in 2021 and 2022 but couldn't overcompensate for the lack of new homes that actually predates the Covid pandemic and since then has coincided with rising wages and a sharp rebound in new household formation.

On the positive side, housing inflation has finally started to slow, and with new household formation and wage growth normalizing, and interest rates eventually biting, it can reasonably be expected to retrace further.

A recent publication by the San Francisco Fed, using asking rents on various platforms as input factors for an econometric model, predicted shelter inflation to drop to 0% until May 2024 but also noted the inherent difficulties in forecasting it. If this scenario materializes, though, core inflation will start to dwindle fast toward the end of this year and is poised to pull the headline CPI with it. Even at 7%-8%, shelter inflation can hardly pull the CPI much higher, again suggesting that a repeat of the double-bulk inflation of the '70s is not likely.
Meanwhile, as shown in the figure above, food and energy prices and production prices are pointing towards disinflation, if not deflation.

Conclusion

It becomes clear from our historical review that the drivers of the subsequent waves in inflation during the '70s and early '80s were quite different from the triggers of recent price surges. An unfortunate coincidence of lousy weather conditions, government intervention, and political turmoil in the Middle East that caused energy and food prices to skyrocket were the main culprits for the primarily supply-driven inflation surge in the '70s. It is also evident that the second wave observable in the late '70s and early '80s was not an inevitable consequence of the first but would not have occurred without the massive disruption caused by the oil crisis.

Similarly, the recent inflationary period has been induced by supply-side shocks, most notably trade disruptions triggered by Covid lockdowns and the energy crisis generated by the war in Ukraine. Easy monetary policy and pent-up demand following the Covid crisis likely aggravated the problem, but as in the '70s was not the root cause.
Energy and food prices remain the most volatile CPI components, and climate change may admittedly carry some upside risk to the latter. Still, their relative importance has decreased since the '70s and '80s as Western households spend a smaller share of their incomes on subsistence while developed economies' energy intensity has generally decreased.

Europe's quick decoupling from Russian oil and gas and the rise of the US' homegrown exploration and production industry also suggest for a lesser vulnerability to future energy shocks.
Supply chain pressure has abated as China is courting investors and shipping rates have normalized. Producer price inflation is negative in large swaths of the world, and it's hard to see why there should be another energy shock in the near term.

With core inflation ex-shelter around 3%, the housing market remains the most important wild card. It is important to emphasize that the drivers of housing inflation today are not the same as in the early '80s when mortgage rates drove up the shelter CPI. Years of sluggish homebuilding activity following the Great Financial Crisis, a jump in new household formation post-Covid, and the significant increase in disposable income have driven up rents over the past year despite elevated construction activity throughout 2021.

Undoubtedly, policymakers will closely watch the evolution of this critical CPI component over the coming months and will determine the near-term path of monetary policy. Suppose shelter prices retrace as expected by the San Francisco Fed's model. In that case, core inflation should revert to target quickly and significantly undershoot our careful scenario in our first graphic that derives future headline prints from current core inflation and expected oil price base effects.

Conversely, a remarkably robust economy with high corporate margins and continuing government stimulus including the energy transition, admittedly has some inflationary potential. If diminished construction activity continues to impede a sustainable decline in the growth of housing rents and rent equivalents, inflation may, therefore, continue to linger around 4%-5% and force the Fed to keep rates higher for longer.
Having said this, in no case would we expect another outburst comparable to the pattern observed during the '70s and '80s.

History often rhymes, but it's crucial to understand how exactly it differed.