The combination of stimulative fiscal and monetary policies along with supply side constraints has led to a dramatic rise in inflation. After increasing just 1.4% in 2020, the Consumer Price Index for All Urban Consumers (CPI-U) increased 7.0% in 2021, 6.5% in 2022 and at an annual rate of 6.4% and 6.0% in the first two months of 2023.
To understand the potential path of future inflation, it is logical to consider what happened during the last major burst—when the CPI peaked in March 1980 at 14.8%. While the current situation is worrisome, the good news is that inflation remains well below that mark—the annual rate peaked at 9.1% in June 2022 and has fallen for eight straight months. Providing a measure of optimism is that, following the strict monetary policy of former Federal Reserve Board Chairman Paul Volcker, the CPI fell to 2.5% by July 1983. And because much less of a decline is needed now to return to the Fed’s target of 2%, perhaps inflation can be brought down to target without a recession. However, making a direct comparison between then and now is problematic because there have been significant changes in the way the CPI is measured, specifically related to housing.
Between 1953 and 1983, the Bureau of Labor Statistics (BLS) produced a measure that broadly captured changes in the expenses of homeowners, including house prices, mortgage interest rates, property taxes, insurance and maintenance costs. Shelter costs were directly affected by monetary policy because of the effect of the federal funds rate on mortgage rates. In 1983 the BLS exchanged homeownership costs for owners’ equivalent rent (OER). By estimating what a homeowner would receive for their home on the rental market, the BLS stripped away the investment aspect of housing. In addition, from a low of 14.5% weight in 1983, as Americans have shifted more of their consumption toward housing, OER has risen to represent 24.3% of overall CPI and 30.6% of core CPI in 2022.
To understand how this change in methodology impacted reported inflation, Marijn Bolhuis, Judd Cramer and Lawrence Summers, authors of the June 2022 study Comparing Past and Present Inflation, constructed new historical series for CPI headline and core inflation that were more consistent with current practices and expenditure shares for the post-war period. They began by noting that the pre-1983 approach produced a volatile shelter series that moved almost in step with the federal funds rate. Much more so than rents, these estimates were responsive to changes in interest rates. During the Fed tightening cycles of 1967–1969, 1972–1974 and 1977–1981, shelter inflation increased sharply, only to fall precipitously when the pace of tightening slowed down. The authors explained: “This method made pre-1983 peak CPI inflation measures, especially during the Volcker era, artificially high at the beginning of the tightening cycle, and declines look artificially fast.” Since the 1983 shift, shelter CPI has been much less volatile—past inflationary cycles would have been less volatile using the consistent methodology that uses OER.
Their new series revealed that current inflation levels are much closer to past inflation peaks than the official series would suggest. While the official core CPI inflation peaked at 13.6% in June 1980, they estimated that core inflation was 9.1% (the same as it was in June 2022) in that same month when adjusting for the treatment of shelter. Their estimates also suggested that the trough of core CPI inflation in 1983 was considerably higher than originally reported. The net effect was that “the rate of core CPI disinflation caused by Volcker-era policies is significantly lower when measured using today’s treatment of housing: only 5 percentage points of decline instead of 11 percentage points in the official CPI statistics.” To achieve that level of disinflation, the fed funds rate, which was at a target level of 14% in January 1980, was raised to its highest target range ever, 19%–20%, in December of that year.
Bolhuis, Cramer and Summers noted that the “differences imply that the responsiveness of the CPI to monetary policy was considerably lower during the 1960s and 1970s than the official CPI statistics suggest. We stress that any consequences of the difference in measurement are larger for core CPI than for headline CPI, due to the considerably larger weight of OER in core CPI.” They also showed that due to the greater weight of transitory goods components (in the early 1950s, food and apparel accounted for close to 50% of the headline CPI, while today they account for about 17%), past inflation spikes were higher and more short-lived than today’s. Services make up a much greater component of today’s spending, and their prices tend to be stickier.
These findings led Bolhuis, Cramer and Summers to warn that “the lessons from the early 1970s for decreasing currently elevated inflation to around 2% are limited.” They cautioned against overly optimistic forecasts of an inexpensive disinflation in the current cycle, as “the disinflation that needs to be achieved now is large by historical standards.”
Unfortunately, there are two other issues that could make the Fed’s task more difficult in bringing inflation to its 2% target.
Tight Labor Markets
Unemployment currently stands at just 3.6%, and with 10.8 million job openings in January, there are about 1.9 jobs posted for every unemployed person. Laurence Ball, Daniel Leigh and Prachi Mishra, authors of the October 2022 study Understanding U.S. Inflation During the COVID Era, found that tight labor markets, as measured by the level of job openings (V) to unemployment (U), help explain why inflation remains elevated: “We find that both V/U and past headline shocks have strong effects on nominal wage growth. These results confirm the common view that labor-market tightness and headline shocks transmit into core inflation through wage adjustment.”
Deglobalization
The pandemic exposed the risks of global supply chains, which had the benefit of holding down inflation. The replication of supply chains, and in particular energy transition, are inflationary because it is necessary to build out all the wind and solar power. Additionally, backup thermal capacity must be built and maintained, all during a period of tight labor markets without supporting infrastructure (such as roads, bridges and electric power) due to decades of underinvestment. While deglobalization might be good for many workers and national security, it has negative implications for the fight against inflation.
Investor Takeaways
Looking backward, we can account fairly well for inflation behavior since the COVID-19 crisis. A tight labor market has pushed up core inflation; headline inflation deviated from core because of sharp rises in energy and auto prices and supply chain problems; low interest rates and a housing shortage drove home prices and rents up dramatically; and pass-through from these headline shocks magnified the rise in core. However, looking forward, as Yogi Berra observed, “It’s tough to make predictions, especially about the future.”
Bolhuis, Cramer and Summers showed that one should be careful in drawing conclusions based on the rapid fall in headline inflation that occurred in the early 1980s, and that it might take very restrictive monetary policy and a significant rise in unemployment to bring inflation down to the 2% target.
Another unknown relates to the role of inflation expectations. In the two decades before the pandemic, long-term inflation expectations were well anchored at the Federal Reserve’s target, making it easier to return actual inflation to target when it was pushed away temporarily. Looking forward, if expectations remain anchored, then inflation might again return to target more quickly. However, the anchoring of inflation expectations is not immutable. A large and persistent enough rise in inflation would lead expectations to be revised upward, which in turn would push actual inflation even higher. That outcome would worsen the unemployment-inflation trade-off and increase the costs of reining in inflation.
Another issue that affects inflation is the decreased role of manufacturing. Seventy years ago, almost one-third of the work force was engaged in manufacturing, a cyclical sector that is much more vulnerable to increases in interest rates than the service sector (which accounts for more than 75% of the GDP).
Today, only 8% of the workforce is engaged in manufacturing. That shift could make it more difficult for the Fed to contain inflation, as it might have to raise interest rates more than currently expected to achieve a sufficient slowdown in total demand. We can see signs of that in the chart below, which shows continuing strong employment growth in the services sector.
While optimists are hopeful that the recent rapid rise in interest rates will lead to inflation moving quickly toward the Fed’s 2% target, several factors may lead to the battle being far from over. Inflation could remain sticky, and the Fed may have to raise rates more than the market currently expects and keep them high for longer; and the economy may have to endure a recession, possibly with a significant increase in unemployment, in order to achieve the inflation target. Investors should be prepared for either scenario to play out. All crystal balls are cloudy.
Larry Swedroe has authored or co-authored 18 books on investing. His latest is Your Essential Guide to Sustainable Investing. All opinions expressed are solely his opinions and do not reflect the opinions of Buckingham Strategic Wealth or its affiliates. This information is provided for general information purposes only and should not be construed as financial, tax or legal advice.