Inflation is not dead? Multiple upward risks still exist!

In the past three years, the description of inflation has changed from "temporary" to "sustained," and then to dull. In developed countries, the year-on-year inflation growth rate is returning to the low level of 2% set by many central banks. Commentators talk about the scenario of the Goldilocks economy, where the economy is neither too hot nor too cold.

However, beware of premature celebrations. Monetary policy makers have often prematurely celebrated the end of inflation, only to be caught off guard by a sudden resurgence of inflation. Perhaps the best example comes from the early 1970s.

Fluctuations in inflation and interest rates in the 1970s

In the late 1960s, due to the Vietnam War and the spending on President Lyndon Johnson's "Great Society" program, the inflation rate in the United States rose. In response, the Federal Reserve raised interest rates to nearly 10% in 1969, leading to a brief economic recession and stock market crash. Subsequently, the inflation rate declined, reaching 2.7% in 1971, close to the current level. By the end of that year, the Fed's official policy rate had returned to 3%. Large-cap stocks flourished. Then, everything collapsed again. In 1974, the inflation rate reached 10%, with interest rates peaking at over 13%, leading to the collapse of the "Nifty Fifty" and a severe recession.

Note: "Nifty Fifty" is an informal term that appeared in a specific period in the history of U.S. stock investment, referring to 50 highly sought-after large-cap stocks traded on the New York Stock Exchange in the 1960s and 1970s.

Several factors help explain why inflation suddenly resurged at that time. In 1971, President Nixon closed the so-called gold window, announcing the end of the fixed exchange rate between the U.S. dollar and gold. At the same time, during his successful reelection campaign in 1972, Nixon pressured Federal Reserve Chairman Arthur Burns to boost the U.S. economy. Both Nixon and Burns prioritized low unemployment over price stability. The following year, OPEC imposed an oil embargo on countries that supported Israel during the Yom Kippur War. As a result, oil prices tripled.

The Fed initially tried to alleviate the energy crisis by lowering interest rates. This action was later criticized by renowned economist Milton Friedman and others. However, if the Fed had prevented other price increases, the entire economy might have collapsed. In addition, a recent study by the International Monetary Fund (IMF) found that historically, "unresolved" inflation is often related to energy shocks.

Legendary investors Gary Shilling and Kiril Sokoloff pointed out several other factors that drove up prices in their 1983 book "Is Inflation Ending? Are You Ready?" These factors include support programs for agricultural products and dairy, as well as tariffs on sugar and Japanese steel. The surge in regulations increased business costs In 1971, Nixon implemented controls on prices and incomes, but as expected, this did not curb the inflation wave. Adjustments to the cost of living for social security and minimum wage spared most Americans from the ravages of inflation. Workers went on strike to maintain their wage differentials. Productivity growth halved. A weak dollar raised import prices. Most of these inflationary forces were self-reinforcing.

Shilling and Sokoloff pointed out the historical connection between the government's growing share of the economic pie (reaching around 40% of the US GDP in 1980) and the spiral rise in prices. The Federal Reserve played a supportive role. After stepping down as Fed Chair in 1978, Burns lamented, "The Fed itself is caught up in the changing philosophies and political currents that are reshaping American life and culture. Yet, at some point, Americans will worry more about inflation than unemployment." Under the leadership of subsequent Fed Chair Paul Volcker, the Fed was authorized to curb inflation, a feat achieved through high interest rates, two severe recessions, and soaring unemployment rates.

Today's situation is not a replay of 1973. Nevertheless, there are still some interesting similarities. Government regulations are becoming increasingly complex. The control of the dollar over the international monetary system is being challenged. Pay raises continue to make headlines. Earlier this month, US dockworkers ended their strike after receiving a 62% pay raise. Boeing employees rejected the troubled aircraft manufacturer's proposal for a 30% pay raise. Vice President Harris has pledged to crack down on price gouging by businesses if she wins next month's presidential election, which to some sounds like a reintroduction of price controls. Her opponent, Trump, hopes to impose high tariffs on imported goods.

Meanwhile, another war is raging in the Middle East. Even though it did not immediately cut off oil supplies from the Gulf of Mexico, the sustainability of mid-term oil supply remains a concern. Exxon Mobil has warned that there could be an oil shortage by 2030 due to insufficient new investments, but the International Energy Agency (IEA) disagrees. According to data from the EU statistics office, the shift to renewable energy since 2020 has pushed up the EU's electricity costs by 45%. Like in the 1970s, higher energy costs (exacerbated by the Russia-Ukraine war) are rendering much of Europe's manufacturing base obsolete. Andy Lees of MacroStrategy Partnership stated that German industrial production has fallen by 14% since its peak in 2017.

European energy costs have soared

Furthermore, global public debt is much larger than 50 years ago. The IMF expects global public debt to reach $100 trillion by the end of this year. Last year, the US fiscal deficit reached $1.6 trillion, accounting for 6.3% of GDP John Cochrane, a finance theorist at Stanford University, proposed a connection between government overspending and inflation, suggesting that it is not a question of whether inflation will return, but rather when it will return.

Sokoloff, the founder and chairman of investment advisory firm 13D Research & Strategy, successfully predicted a shift in inflation 40 years ago. Today, he is not as optimistic. In his view, there still exists significant long-term drivers for price increases. In the coming years, deglobalization, military restructuring, de-dollarization, aging populations, climate change, and energy transition will continue to exert upward pressure on inflation. Similar to the early 1970s, there is no political willingness to control prices through high real interest rates or to manage government finances through austerity measures.

Sokoloff stated that gold has long been a reliable barometer for measuring inflation and deflation. Since the beginning of this year, the price of gold has risen by nearly 30%. This seasoned analyst suggests that this indicates the end of 40 years of deflation, with bonds now in a long-term bear market. Inflation has not disappeared, just taken a brief respite