Tuesday 22nd of October 2024
When inflation started to surge globally in 2021, many economists and policymakers debated whether it was “transitory” or likely to be a prolonged issue.
The word “transitory” was commonly used to describe price pressures that would resolve themselves once the supply shocks and economic imbalances from the pandemic eased. But as inflation persisted longer than anticipated, many were quick to dismiss the transitory narrative, likening the situation to the sustained inflation of the 1970s.
In hindsight, however, there is a growing argument that inflation over the past few years bears more resemblance to the inflationary period following World War II in the late 1940s than the infamous stagflationary spiral of the 1970s. This shift in perspective suggests that policymakers may have been overly concerned with avoiding the mistakes of the 1970s, when in fact this inflationary episode had much more in common with the post-war period.
The inflation of the 1970s was driven by a combination of factors, including demand-pull inflation, cost-push pressures from oil price shocks, and wage-price spirals. It was a period of stagflation; high inflation coupled with slow economic growth and high unemployment. In response, central banks, particularly the Federal Reserve under Paul Volcker, took aggressive measures, pushing interest rates sky-high to rein in inflation. Volcker’s draconian monetary tightening is often credited with ending the inflationary spiral, though it also led to a severe recession in the early 1980s. Policymakers ever since have taken this episode as a cautionary tale, believing that sustained inflation can only be tamed through aggressive tightening, and that failure to act early can result in entrenched inflation expectations.
This 1970s legacy loomed large in 2021 when inflation began to rise. There was an overwhelming fear among policymakers and market participants that allowing inflation to run even slightly hot could result in a similar spiral, where inflation expectations become unanchored, leading to wage demands and price-setting behaviour that could entrench inflation for years. This is one reason why central banks, led by the US Federal Reserve, raised interest rates at a historically aggressive pace from 2022 onwards.
However, a growing body of evidence now suggests that this bout of inflation may have more in common with the late 1940s, when inflation also surged as a result of a massive, temporary dislocation of the global economy due to World War II. In that period, inflation spiked due to a combination of pent-up demand, supply shortages, and the unwinding of price controls. Inflation in 1946 and 1947 was intense, with prices rising at double-digit rates, much like they did in 2021 and 2022. However, the inflationary pressures were largely transitory, resolving themselves as the economy adjusted to peacetime production, supply chains normalised, and the temporary mismatch between demand and supply abated.
In both cases, the late 1940s and the early 2020s, the inflation was primarily driven by supply-side disruptions rather than excessive demand. In the 2020s, the COVID-19 pandemic caused widespread supply chain disruptions, labour shortages, and shifts in consumer demand patterns.
One of the key factors that distinguishes the inflation of the 2020s from that of the 1970s is the supply-side nature of the price pressures. The 2020s inflation was largely driven by supply chain disruptions, semiconductor shortages, labour market tightness, and energy price volatility exacerbated by Russia’s invasion of Ukraine. These are predominantly supply-side issues, and once resolved, the inflationary pressures would naturally subside. In contrast, the inflation of the 1970s was more demand-driven, with oil price shocks compounding pre-existing inflationary pressures from over-expansionary fiscal and monetary policies.
By late 2023, many of the factors that had driven inflation higher were showing signs of easing. Global supply chains had begun to normalise, energy prices had come down from their post-Ukraine invasion peaks, and labour markets were starting to cool. Even where inflation remained somewhat sticky, such as in the services sector, it was increasingly clear that the worst of the inflationary pressures had passed. This easing of supply-side constraints mirrors the pattern seen in the 1940s, when inflation cooled once the supply-demand imbalances caused by the war were resolved.
In hindsight, the inflationary pressures of the early 2020s appear to have been driven largely by temporary, supply-side disruptions, much like the inflation experienced in the aftermath of World War II. While inflation persisted longer than many had initially anticipated, it has increasingly shown signs of cooling as supply chain issues have been resolved and global economic imbalances have normalised. Policymakers’ bias toward avoiding a repeat of the 1970s may have led to overly aggressive tightening. As inflation continues to moderate, this period may ultimately be remembered as a bout of transitory inflation driven by unique, temporary factors, rather than the beginning of a new era of sustained inflationary pressure. And that is good for the outlook for risk assets!
We would like to thank Dominion Capital Strategies for writing this content and sharing it with us.
Sources: Bloomberg, Yahoo Finance, Marketwatch, MSCI.
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