Inflation Article | ivylinecapital

Blast From the Past: How the Post-Pandemic Economy Looks Like The Great Inflation

June 4, 2021

Sixteen months into weathering the global COVID-19 torrent, we’re beginning to see glimmers of getting back to “normal” and reinstating some version of reality as it was before March 2020. People are going back to the office, attending large-scale events and even scheduling vacations—all signs of a return to life before anyone ever heard the word “COVID.” But trying to restore the pre-pandemic economy just might be a fool’s errand.

Pandemic or not, no two periods of economic history are precisely the same, so striving to replicate or return to what we lost before 2020 is simply unrealistic and, frankly, impossible. Instead, we need to turn the page, look to the future and build an economy for the here-and-now.

Sixteen months into weathering the global COVID-19 torrent, we’re beginning to see glimmers of getting back to “normal” and reinstating some version of reality as it was before March 2020. People are going back to the office, attending large-scale events and even scheduling vacations—all signs of a return to life before anyone ever heard the word “COVID.” But trying to restore the pre-pandemic economy just might be a fool’s errand.

What you need to know: The Great Inflation

Sixteen months into weathering the global COVID-19 torrent, we’re beginning to see glimmers of getting back to “normal” and reinstating some version of reality as it was before March 2020. People are going back to the office, attending large-scale events and even scheduling vacations—all signs of a return to life before anyone ever heard the word “COVID.” But trying to restore the pre-pandemic economy just might be a fool’s errand.

Let’s rewind 50 years and learn about what economists call The Great Inflation. The year is 1971. At this point, President Nixon had already pressured his Fed Chairman, Arthur Burns, into slashing interest rates in an attempt to stimulate the economy. But that couldn’t fix the slumped stock market and elevated unemployment, and economists were beginning to detect an inflated economy.

Nixon’s response was signing an executive order to freeze wages and prices of goods, including gas and oil, in addition to levying a 10% duty on imports, among other things. These extreme measures were later called “Nixon Shock.” His executive order set the controls for 90 days, although they ended up lasting more than 1,000 days. By 1974, the damage was done.

Instead of preventing inflation, Nixon Shock stoked the flames of a too-hot economy. Inflation, which was sitting at about 4% when these measures were taken, reached 12.3% in 1974. In those three years, oil and gas became scarce, and unemployment inched up two percentage points to 7.2% in 1974. Unemployment during The Great Inflation peaked at 8.2% in 1975.

There are many arguments about what caused this unprecedented period of inflation in the U.S. Economy. Nixon famously blamed it on OPEC and greedy union bosses. And the American people were obliged to agree. Nixon resolutely defeated Senator George McGovern in 1972, winning every state but Massachusetts.

The fact is, there isn’t a smoking gun here. Many things contributed to The Great Inflation, the monetary policies of the Nixon Presidency not least among them. After all, it took two more presidents and nearly a decade before the damage incurred by Nixon’s overreach of executive power was reversed.

What you need to know: The Post-Pandemic Economy

Fast forward to 2020, and we’re dealing with a completely different economic storm. The year began on several high notes. At the beginning of 2020, unemployment was at a 50-year low of 3.5 %, GDP sat at $22.01 trillion, and inflation was low at around 2%. The stock market reached a fever pitch, buoyed by the S&P’s 15.8% gains in the six months leading up to the pandemic.

But after March 2020, all that came crashing down. The following month, pandemic unemployment peaked at a shocking 14.7%, and the Q2 GDP diminished by an unheard of 31.40%; both numbers were records last set during the Great Depression. Inflation remained low, but the stock market bottomed out on March 23, 2020, after losing 37%.

As of June 2021, unemployment sits at a still elevated but much better 6.1%. The GDP is roaring back, reaching $20.9 trillion by the end of 2020, and the International Monetary Fund (IMF) predicts U.S. GDP will enjoy 6.3% growth in 2021. The stock market has more than made up for its pandemic-era losses, but what about inflation?

The economies of the 1970s and 2020s are worlds apart. There are entire categories of business comprising a great deal of the modern economy that simply didn’t exist 60 years ago (and vice versa). But when you get down to the nuts and bolts of capitalism, are they really that different? The striking similarities in these markets should make any financier worth their salt wonder, are we headed for a repeat of The Great Inflation?

The case for inflation in 1971 and 2021

The economies of the 1970s and 2020s are worlds apart. There are entire categories of business comprising a great deal of the modern economy that simply didn’t exist 60 years ago (and vice versa). But when you get down to the nuts and bolts of capitalism, are they really that different? The striking similarities in these markets should make any financier worth their salt wonder, are we headed for a repeat of The Great Inflation?

Similarity #1: Preceded by a strong economy

In the years leading to the crescendo of the Great Inflation in 1974, GDP was strong and inflation only slightly elevated. The U.S. economy enjoyed a 3.3% gain in 1971 after having nominal growth of 0.2% in 1970. GDP gains were even more substantial in 1972 and 1973, reaching 5.3% and 5.6%, respectively. Unemployment was slightly elevated at 6.1% in 1970, but that had fallen to 4.9% (regarded as a healthy level) by 1973. Although higher than the Fed’s recommended level of 2%, inflation also sat at a little over 3% in 1971 and 1972.

By all accounts, the 1970s were set to bring prosperity to the U.S. economy. The numbers weren’t perfect, but political leaders thought they were manageable and hoped to steer them downward in the months to come. Many historians argue that the perceived prosperity is what propelled Nixon’s reelection in 1972.

We’re in a similar situation in 2021. Now that the 2020 pandemic disruptions are behind us, this year is looking up. After months of dramatic shifts in U.S. unemployment, circumstances appear to have normalized... for now. Since November 2020, the rate has hovered around 6% and was at 6.1% (the same level observed in 1970) in April 2021. Interestingly, this was the first increase in unemployment (.1%) observed since peaking at 14.8% in April 2020.

The IMF’s projections show U.S. 2021 GDP eclipsing 2019 levels, increasing to as much as $22.2 trillion. Inflation is also slightly elevated at 4.2%, not unlike the inflation rates seen in 1972, just before sharply increasing in 1973 (to 8.7%). Favorable market conditions in the early ’70s and today seem strangely similar, which is why many are beginning to wonder, are we headed for the same fate?

Similarity #2: Happened on the heels of a national emergency

In 1973, President Nixon closed the chapter on the Vietnam War. The Great Inflation ballooned into the U.S. economy just as the last troops were heading home from Vietnam. The following year, in 1974, inflation skyrocketed to 12.3%, the highest rate recorded since WWII.

Unemployment also hit a new high for that decade at 7.2% in 1974. Although, the situation would worsen in 1975 when unemployment set the record for that decade at 8.2%. It hadn’t been that over 8% since 1941. You could argue that the GIs who came home in 1973 and began looking for work contributed to this increase in unemployment, but that alone couldn’t cause such a significant jump. Something else was at work here.

To say that the COVID-19 pandemic was a national emergency is an understatement. This global crisis upended every aspect of life, including the economy. Inflation and unemployment were both lean in 2019, the last “normal” year before the shutdowns. Inflation rang in at 2.3%, while unemployment was a minuscule 3.5%. In 2021, both rates have nearly doubled, with inflation sitting at 4.2% and unemployment at 6.1%. Despite the turbulence of 2020, much of the U.S. economy has recovered. But many signs are pointing to an inflated market, just as we saw in the early 1970s.

Similarity #3: Low interest rates

Nixon began a policy of slashing interest rates at the beginning of the 1970s. By the end of 1971, interest rates hit a decade-low of 3%. Rates fluctuated between 3 and 5.5% through the end of 1972. From there, they began to steadily increase for the remainder of the decade, ending at a near-record high of 14.04%.

The economy of late has seen even lower interest rates. Rates were as low as 0.05% in May 2020, just two months after the pandemic downturn. They’ve continued to hover in that range and currently sit at 0.05%.

The motivation for lowering interest rates is always economic stimulation. The lower the interest rates, the more likely people are to borrow and spend money. Lowering rates is a well-known tactic to produce short-term economic booms, but the benefits end there. In the long term, low interest rates are also symptomatic of inflated markets.

Lowering interest rates, as seen during The Great Inflation, can have perilous consequences. Ed Yardeni of Yardeni Research summed up the danger of prolonged low interest when he said, “Too much of a good thing is often just too much. The economy is hot and will get hotter with the bonfire of the fiscal and monetary insanities.”

Similarity #4: Personal Consumption Expenditure (PCE) Price Index on the rise

According to the U.S. government, a healthy economy has a PCE of about 2%. In times of inflation, PCE increases when costs of goods and services increase without proportional rises in income. This key inflation metric averaged 6.8% during the 1970s. Now, PCE stands at 3.1%, a whole percentage point above what the government considers healthy. The most recent trends indicate PCE will increase in the coming months.

High PCE levels in the ’70s and today are no coincidence. In both decades, the cumulative economic forces were ripe for inflation. The increase of PCE and its direct relationship to rising inflation was confirmed 60 years ago and is unfolding in real-time today.

Similarity #5: Scarce commodities

Even if you didn’t live through the 1970s, you’re probably familiar with scenes of long lines waiting for gas during that decade. The Arab oil embargo, which began in 1973, sharply decreased the U.S. access to oil and, consequently, gasoline. At the time, many Americans struggled to fill up their tanks. And when oil prices go up, the prices of goods and services go right along with it. Inflation was already high in 1973 at 8.7%, but it increased by nearly four percentage points to 12.3% the following year.

The 1970s saw shortages of other commodities, like grain, as well. The collective supply issue of necessary, life-sustaining goods played a prominent role in the inflation economy of that decade.

The COVID-19 pandemic caused more shortages than we can reasonably name. Everything from toilet paper to lumber to packaged meat and essential medical equipment became scarce at one point or another in 2020. And as a result, the cost of these and other goods increased. For example, the National Association of Home Builders reported that prices for lumber alone have risen by more than 200% since April 2020.

Although the economy is still grappling with decreased supply of lumber and other goods, In 2021, consumers will face a new kind of shortage which, perhaps, will prove to be the most challenging: microchips.

These semiconductors are an essential component of many consumer electronics, cars and manufacturing equipment. In 2020, suppliers of these parts, primarily affected by the pandemic-inflicted work stoppage, were restricted in the number of chips they could produce and ship.

But during this time, demand for microchips increased as consumers needed more tech to meet the social distancing demands of living during a pandemic. The result was the classic “bullwhip effect,” when inventory levels suddenly fluctuate because of unexpected customer demand changes. Customers can still get products made with these chips, but they’ll pay an increased price and probably wait several months for something they’ve ordered. And, as they are waiting, demand will continue to grow.

Costco CFO Rich Galanti said it best, "Chips shortages are impacting many items from an inflation standpoint, some items more than others. And with regard to containers and shipping, transportation costs have increased as well.”

Similarity #6: Increased spending on social welfare

In 1972, President Nixon signed the Social Security Amendments into law, vastly expanding this cornerstone of American retirement. These amendments initiated a 20% across-the-board increase for all Social Security beneficiaries. They also began the practice of awarding annual cost-of-living increases to account for inflation and other economic forces out of beneficiaries’ control.

Whether or not these reforms were needed or effective is a conversation for another day. The important thing here is that the government expanded a program to provide for the social welfare of a specific group during a time when the economy was ripe for inflation. The inflation rate was 3.4% the year Nixon signed the amendments into law. The very next year, 1973, the U.S. faced the highest inflation rate it had seen in a generation (8.7%).

The COVID-19 pandemic brought about similar dramatic increases in social welfare spending in 2020 and 2021. Since the pandemic began, the U.S. government has given the average family of four $11,400 in stimulus dollars. Lawmakers voted to further supplement this amount with another $6,000 taxpayers with children will receive in July 2021 (in the form of $500 monthly payments through December and a $3,000 payout on 2021 tax returns).

So, even if no additional stimulus packages are signed, the average family of four will receive a $17,400 stimulus package once they get their 2021 tax return.

These payments, designed to prop up the economy by enabling and empowering people to buy, are a temporary solution to economic uncertainty. But they’re going to cause a long-term problem. The more “free money” is floating out there, the more demand (and prices) will increase. Are wages going up, as well? For most American workers, the answer is no. So when prices rise, and there’s no more stimulus money to be had, what, then?

The more free money is made available, the more demand will increase. Higher demand means higher prices. But when prices go up without sustained increases in income, the more likely inflation becomes.

Wharton professor Jeremy Siegel characterized the economic conditions in the 1970s this way: "the greatest failure of American macroeconomic policy in the postwar period." If we fail to act on the signs of inflation now, we exponentially increase the likelihood of a similar failure.

The 1970s and 2020 are two vastly different decades, but are their economies really that divergent given the congruent economic conditions? Many signs are pointing to a repeat of The Great Inflation, and that’s something this recovery just can’t afford.