On Inflation, If You Don’t Study History...

Superficial comparisons between today’s inflation and that of the 1970s fundamentally misunderstand what happened then. The 1970’s inflation was not driven by a “supply shock” as oil prices rose, but rather by a “demand shock” as the US dollar depreciated, forcing oil producers into a competitive cycle of price hikes to preserve real income relative to a benchmark such as gold. At the same time, progressive US tax brackets were not indexed for inflation, so rising wages in response to a depreciating dollar were taxed at higher rates – a formula for stagflation. The solution was restrictive interest rates and pro-growth tax reform, including indexation of brackets. There is no evidence of these forces at work today. Now we are experiencing true supply shocks, against the backdrop of monetary expansion that is inherently one-time in nature. The trade-weighted dollar is strong, gold is quiescent and risk indicia such as Treasury yields, credit spreads and long-term inflation breakeven spreads are at historically unremarkable levels – all very unlike the 1970s experience. The Fed knows that CPI inflation is a lagging indicator, and that there is little it can do about food an energy prices, without causing a politically unacceptable amount of economic damage. We stand far apart from the consensus: we think the path of policy normalization won’t accelerate, but will slow to a mere 25 bp hike in September.