The CPI report came out Tuesday, and the headline number showed a 12-month inflation of 3.2%. The running average of CPI going back to 1914 has been 3.3%. So, what should we take away from this number, seeing that market participants are still worried about 1970s inflation and some don’t want to see any rate cuts this year?
Fed presidents and others have cited the fear of 1970s-style entrenched inflation as a reason they hiked rates so fast and are being careful as they consider rate cuts. However, is the 1970s reference a valid one? After today’s inflation report, is this even a possibility with the current economic conditions?
The deflation question is an easy no: the history of deflationary collapses post-WWII is non existent. This is an issue from the 1800s. As long as people are working and the economy is expanding, it is rare to see deflation in the CPI numbers.
But what about the 1970s inflation that led to 18% mortgage rates in the early 1980s? For this to happen, we would need to see a few big key variables which aren’t happening currently.
Today’s CPI report
From BLS: The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.4 percent in February on a seasonally adjusted basis, after rising 0.3 percent in January, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index increased 3.2 percent before seasonal adjustment.
The year-over-year core inflation data have been slowing down on all the inflation reports; CPI, PPI, and PCE have slowed from the COVID-19 peak. The core PCE inflation data that the Fed focuses on is at 2.8% yearly, which is a far cry from the 1970’s 10%.
In today’s CPI print, core inflation today is running at 3.76%. How is this possible when the stock market has recovered, the labor market is intact, and the economy is growing above trend? We were told inflation couldn’t possibly cool down with all those three variables happening. Well, it did!
Remember that in the 21st century, it was difficult even to keep core PCE inflation above 2%. The global pandemic created supply shortages, an extra boost in demand for goods over services, and a massive burst in inflation. Like all pandemics, disinflation follows the pandemic inflation boost as supply chains improve.
Can the 1970’s inflation return?
So, how do we get the 1970s inflation growth rate with an economy currently outperforming? This is a damn good question! One of my running jokes over the last year has been that we have people saying we are in a recession but that we can’t cut rates because the economy is too strong. Both of those things can’t be true at the same time, so you need to pick one. You can say that the tight labor market that pushed up wages is cooling off. Here’s my latest article on the jobs report, which shows the labor market isn’t tight anymore and wage growth is cooling down.
Why is this key? If the labor market cools, wage growth slows down, making it challenging for rent inflation to grow much faster. If 44.4% of CPI is shelter, you need a booming housing market again to push rents higher than what we saw at the peak of the global pandemic. Good luck on this by the way.
The 1970s saw wage growth, labor force growth, and a lack of housing, facilitating the housing boom and rent inflation. That’s not happening now; if anything, rent inflation is artificially too high.
Also, we have a lot of supply coming online in the five-unit sector, which will keep rent growth cool for apartments and less for single-family homes. One crazy idea that can boost inflation is if the government forces investors to sell their homes, kicking out renters and limiting the supply of rented homes. That is an evident supply argument because fewer single-family homes to rent would boost inflation. However, I don’t see this happening. What about the government giving tax breaks to investors to sell their homes? It’s not good for politicians to make investors more money while families are booted out of their single-family rental units.
What about a supply shock?
To get anything that looks like the 1970s inflation today, we would need to see a supply shock and one that lasts a long time. We had an oil shock back in the 1970s which would amount to oil prices today — adjusted for inflation — of about $450/barrel. Instead oil is $78/barrel today.
Here is my model for 1970s inflation returning. We would have to have war around the world: China going to war with Tawain, Russia using oil and wheat as a weapon of choice against western economies and Iran continuing to have their pirates attack ships in the Red sea. This would force headline inflation to rise, and as long as it sticks, wage growth would have to compensate, leading to core inflation rising with it.
This model assumes the variables above would happen for a long time, forcing U.S. companies to compensate their workers for the higher cost of living. However, you get my point here: we would need a supply shock the size of Godzilla. The economy and the stock market are doing fine, but inflation doesn’t look like in the 1970s because the supply markets are returning to normal.
Can the 1970s inflation return and bring double-digit mortgage rates heading toward 18%? In theory, yes. In reality, no. Unless you get a massive supply shock, it’s hard to get inflation that high again and sustain itself.
For a long time, people said we couldn’t bring the inflation growth rate down if the economy expanded. Some people said we needed high levels of unemployment for many years to bring down inflation. Well, the unemployment rate is under 4% and the inflation growth rate is much closer to what we saw in the last decade than the inflation growth rates of the late 1970s. So, take those disco pants and give them to the Salvation Army. It’s a new world, and we must leave that period behind us.
ENB
Sandstone Group
