Background

Inflation is important to investors for several reasons.

It erodes real wages and the purchasing power of money over time, and the real return on investment.

It makes asset values seem high despite there being no growth in real value.

It influences interest rates set by central banks and directly impacts the value of bonds.

It impacts different assets in different ways and is an important factor when considering relative investments and diversification.

It also impacts long-term planning for those saving for retirement, and it is an indicator for instability, policy response, and overall portfolio allocation.

That makes it one of the most important macro drivers.

Generally, central banks in developed economies seek to achieve price stability mandates by targeting a ‘goldilocks’ inflation rate range of between 2% and 3%.

That’s what the RBA targets, whereas the U.S. Federal Reserve (the Fed) targets 2%.

And the Fed’s been pretty clear about wanting to stamp out this current wave of high inflation and get back to 2%.

Why? so that higher prices (expectations) don’t get baked in, and/or come back in multiple debilitating waves like they did in the 1940s and the 1970s.

In the 1940s, it took a barrage of liquidity sucking war bonds, price controls, rationing and monetary tightening after the war under the Eccles Fed to finally kill off several waves of inflation.

In the oil shock decade of the 1970s which also experienced multiple inflationary waves, it took several attempts from the Volcker Fed to kill it off, eventually by hiking interest rates to 19%.

While today’s inflationary drivers of QE + COVID Fiscal + Russia supply shocks/OPEC are slightly different to the drivers of the 1940s and 1970s, those two past decades are instructive when considering what might happen to consumer prices if central banks were to ‘back off’ their tightening policies, too early.

Let’s jump into those waves.

Key periods of inflation in modern history

There have been several periods of significant inflation in modern history. Here are a few:

Hyperinflation in Weimar Germany (1920s): In the aftermath of World War I, Germany experienced one of the most extreme cases of hyperinflation in history. Prices skyrocketed, and people pushed wheelbarrows of currency to buy basic goods. This hyperinflation resulted from war reparations and the government's decision to print excessive amounts of money.
World War II (1940s): The 1940s was characterised by inflationary challenges due to the economic demands of the war. These challenges were managed through war bonds, price controls, rationing, and careful monetary policy by central banks.
Latin American Inflation (various periods): Several Latin American countries, such as Venezuela (more recently), Argentina and Brazil have experienced bouts of hyperinflation and high inflation, and often linked to fiscal mismanagement, external debt, and currency devaluations.
Oil Crisis and Stagflation (1970s): This decade saw global inflation driven by rising oil prices due to geopolitical events. The oil crisis of 1973 and 1979 led to oil price spikes, which, in turn, contributed to higher inflation and economic stagnation in many countries.
Post-Soviet Inflation (1990s): After the collapse of the Soviet Union, many former Soviet republics and Eastern European countries experienced high inflation rates as they transitioned to market economies. These inflations often caused currency devaluations and economic shambolism.
Zimbabwe Hyperinflation (2000s): In the late 2000s, Zimbabwe went through a period of hyperinflation driven by economic mismanagement and political instability. Prices rose at an astronomical rate, and the country printed increasingly higher denominations of its currency.
Post-COVID/Russia Inflation (2020s): We are currently living through a period of high inflation caused by pent-up demand from COVID lockdowns, supply side shortages, and geopolitical /supply chain recalibrations. It’s also been fuelled by the QE train to nowhere and a high USD.

These examples highlight that inflationary periods have occurred in various parts of the world for many and varied reasons. Each had its unique causes and consequences, but they all resulted in significant inflationary pressures.

But two of those periods are more comparable to what we are experiencing now.

The 1940s and the 1970s

These two periods are often considered similar in terms of their economic characteristics, particularly in relation to inflation and economic policies.

Here's why:

High Inflation: Both periods experienced high inflation that occurred in multiple waves. During the 1940s, inflation was primarily driven by the economic demands of World War II, while in the 1970s it was influenced by a combination of rising oil prices, wage-price spirals, and supply shocks. But these came in waves.
Government Intervention: In both decades, governments played a significant role in managing the economy. In the 1940s, government spending was a crucial driver of economic activity during and after the war. Price controls were imposed on a wide range of consumer goods, including food, clothing and gasoline. In the 1970s, governments attempted to control inflation through wage and price controls and other interventionist measures including the price controls that were imposed on oil and gasoline after the 1973 oil embargo.
Monetary Policy: In both periods, monetary policy faced challenges in dealing with inflation. Central banks, had to grapple with the difficult task of trying to balance economic growth with inflation control.
Energy Shocks: Both decades experienced significant energy-related shocks. In the 1940s, it was the disruption caused by World War II, which affected global energy markets. In the 1970s, there were oil price shocks, including the OPEC oil embargo in 1973 and the Iranian Revolution in 1979, which led to substantial increases in oil prices and contributed to inflation.
Labour Market Pressures: Labour market dynamics played a role in both decades. In the 1940s, strong demand for labour during the war led to wage pressures. In the 1970s, unions and workers' demands for higher wages contributed to inflationary pressures.

There are many similarities between the 1940s and 1970s. That said, the 1940s were largely shaped by the economic demands of World War II, while the 1970s saw a combination of factors, including energy shocks and changing labour dynamics, contributing to inflation.

But in both cases, inflation came and went in waves.

Plus, the 5 elements discussed above are highly comparable to what we are seeing today in the aftermath of World War COVID, lockdowns, reopens and energy shocks following sanctions on Russian oil and gas following its invasion of Ukraine.

But before we compare those events to what’s happening now, let’s take a quick look at the tidal nature of inflation during those two historical periods.

Comparing Inflation Waves: The 1940s and 1970s Economic Turbulence

The 1940s and 1970s stand out as two decades marked by stubbornly high inflation.

There were some striking similarities between these two periods as well as differences, but each was characterised by the presence of up to three distinct waves of inflation.

Here’s a quick summary of what caused inflation to increase, decrease, and then rise again multiple times, within each era.

The 1940s - Inflation Waves and Causes:

In the 1940s, the world was engulfed in the turmoil of World War II, and the global economy underwent significant transformations.

During this decade, we witnessed the emergence of three distinct waves of inflation, and here they are 👇

They can best be described as:

Wave 1 - The War Effort: The initial surge in inflation during the early 1940s was mainly due to the demands of the war effort. Governments worldwide ramped up spending on military production, leading to increased demand for goods and services. This demand-pull inflation marked the first wave.
Wave 2 - Post-War Adjustments: As World War II came to an end, economies transitioned from wartime production to civilian goods. This shift, combined with pent-up consumer demand, contributed to another wave of inflation and the removal of price controls and government interventions led to supply-side pressures.
Wave 3 - Demobilisation Challenges: The post-war period saw the return of millions of soldiers to civilian life, posing challenges to the labour market. Wage pressures and strikes ensued, contributing to a third wave of inflation in the late 1940s.

The 1970s - Inflation Waves and Causes:

Fast forward to the 1970s, and we find another decade marked by inflationary challenges, characterised by the presence of three distinct waves as per 👇

They can best be described as::

Wave 1 - Oil Shocks: The early 1970s began with the first oil shock in 1973 when OPEC imposed an oil embargo. This event led to a dramatic increase in oil prices, causing cost-push inflation. It was a period of economic uncertainty and supply-side shocks.
Wave 2 - Stagflation: The mid-1970s witnessed an unusual phenomenon known as stagflation, where high inflation persisted alongside stagnant economic growth. Wage-price spirals and increased labour demands contributed to this prolonged second wave.
Wave 3 - The Late 1970s Surge: Toward the end of the decade, another wave of inflation emerged, driven by geopolitical events including the Iranian Revolution in 1979 and further oil price increases. These events added additional supply-side pressures.

Understanding the fluctuations in inflation within each decade requires considering a multitude of factors, but they broadly included a different mix of demand and supply dynamics caused by extraordinary events, government policy interventions/responses, and labour market pressures.

All of these are present in today’s era of high inflation.

But before going back to the future, let’s go back to the past to find out how those inflationary waves were eventually tamed.

How the wars on inflation were won

The 1940s

In the 1940s, inflation was difficult to manage due to the exogenous demands of World War II.

It was ultimately defeated through a combination of fiscal and monetary policies. The issuance of War Bonds by the U.S. government played a crucial role by redirecting consumer spending toward financing the war effort and away from the civilian economy. Price controls were implemented to freeze prices for essential goods, preventing excessive inflation. Rationing further limited consumer spending.

The Fed, under Chair Eccles, pursued accommodating monetary policies during the war to support government borrowing but shifted to tightening policies after the war to prevent post-war inflation.

This combination of fiscal and monetary discipline, along with the effective management of consumer demand, played a pivotal role in defeating inflation by the end of the 1940s, setting the stage for post-war economic stability and growth.

The 1970s

The 1970s witnessed a prolonged period of inflation in many countries, driven by factors such as oil price shocks and wage-price spirals. To defeat this inflation, policymakers implemented a series of measures.

Central banks, including the Fed, adopted tight monetary policies, raising interest rates to curb demand and reduce inflationary pressures.

Governments, like in the U.S. implemented wage and price controls to control inflation directly. Efforts to reduce reliance on oil imports and develop domestic energy sources aimed to mitigate the impact of oil price shocks.

Ultimately, these policies, combined with a shift in economic focus toward combating inflation, helped bring down inflation rates by the end of the 1970s.

Additionally, the lessons learned from this period contributed to the development of inflation-targeting frameworks and an emphasis on price stability in monetary policy, which have since played a key role in controlling inflation in many economies around the world.

How will today’s war on inflation be won?

It’s hard to tell but given the similar features of the 1940s and 1970s, probably in the same way, and we may see inflation express itself more than once, i.e., over two or three waves like it did back in the day.

That said, this time the Fed was very late to the party, and as I discussed in ‘Winter 2023, Roaring 20s, bear trap?’: the Fed waited one full year after >3% inflation appeared to announce interest rate lift-off (in March 2022).

Hence, the lift-off looked like one of Elon’s Falcon Rockets 👇

In fact, it’s one of the only times where we have seen such a big gap between the emergence of high inflation and the Fed acting (i.e., the other period was after the GFC but this was not high inflation as it hardly averaged 2% even with the Fed’s QE train to nowhere going full throttle).

And being late to the party was probably Chair Powell’s reason for wanting to achieve maximum escape velocity, with large interest rate hikes in the early days of the tightening cycle.

But his rate rocket is still up there and there’s no sign of it coming down any time soon.

In any event, if we assume history often rhymes, we may well be in for one or more waves of inflation after this one subsides and before the Fed feels it’s time to move from restrictive, to accommodative policy.

May the waves be shallow.

Mike

Will inflation come in waves, like the 1940s and 1970s?