DEEP DIVE: Inflation: The 1970s Again?

US Economy I: Raising Odds of a Recession a Tad

On July 31, Debbie and I lowered our odds of a recession. We wrote: “Our script has played out as expected so far. The soft-landing scenario looks increasingly like a no-landing one. As a result, we are raising the odds of a no-landing scenario from 75% to 85% and lowering the odds of a hard-landing scenario from 25% to 15% through the end of next year.” On August 21, in response to the backup in bond yields, we wrote: “We currently are still assigning 85% odds to a no-landing scenario through the end of next year and 15% to a hard-landing one. However, we are leaning toward lowering the former and raising the latter.” Today, in response to several new developments, we are raising the odds of a recession before the end of next year from 15% to 25%.

We remain in the rolling-recession-and-recoveries camp for now. However, the 30% increase in a barrel of Brent crude oil since June 27 is a concern (Fig. 1). It has resulted in an 8.2% increase in the retail price of gasoline since late June to $3.94 during the September 11 week (Fig. 2). If the price of oil breaches $100 per barrel and the price of gasoline rises solidly above $4.00 a gallon and both remain above those levels for a while, they could trigger a renewed wage-price spiral and higher inflationary expectations.

That scenario would be reminiscent of the 1970s, when the first wave of inflation was followed by a second wave and both triggered recessions (Fig. 3). That is not the scenario we consider most likely, but it is the risk to our happier outlook. It’s partly because of this risk that we’ve raised our subjective odds of this alternative scenario to 25%.

US Economy II: Dueling Decades

Now consider the following comparison of the 1970s and the 2020s (so far):

(1) The dollar. The Great Inflation of the 1970s actually started during the second half of the 1960s. It was triggered by President Lyndon Johnson’s decision to deficit-finance the Vietnam War rather than to increase taxes to fund the war. The same can be said about his Great Society initiative. A result of this guns-and-butter approach to fiscal policy was higher inflation.

President Richard Nixon continued that approach during the early 1970s and exacerbated inflation by closing the gold window on August 15, 1971, which caused the dollar to depreciate significantly. The weaker dollar boosted commodity prices and caused OPEC to drive oil prices higher during the 1970s.

This time, several rounds of fiscal stimulus programs combined with ultra-accommodative monetary policies caused a demand shock that overwhelmed supplies, unleashing the current bout of inflation. The programs presumably were aimed at offsetting the negative impact of the pandemic on workers. More accurately, they were another example of Washington’s politicians “never letting a good crisis to go to waste” (in the words of Rahm Emanuel, spoken when he was chief-of-staff in the Obama administration).

What’s different this time is that the US dollar is strong. The Fed has been more aggressive in tightening monetary policy in response to inflation than the other major central banks. Also, the US economy is performing much better than the other major economies, which likewise supports the dollar.