History can be a powerful tool, particularly in a high-inflation environment like this one in which no suitable economic model seems to apply.
Inflation — running at 8.3% as of April, near a four-decade high — has stayed stubbornly persistent for a full year to the surprise of virtually everyone who tracks it. Now there’s a risk that price gains could take much longer than expected to fall back down, even when the Federal Reserve is aggressively hiking interest rates.
That risk was highlighted on Thursday by BofA Securities strategists Vadim Iaralov, Howard Du and others, who point to the period between 1974 and 1988 as the most comparable time in which the annual headline U.S. consumer-price index was rising at a pace similar to the U.S.’s pandemic era of 2019-2022.
In 1980, with the Fed’s main policy rate target already above 10% for most of that year, the annual headline CPI, also in double digits, still did not fall back below 3% after 36 months “even on the back of unprecedented rate hikes enacted by Fed Chairman Paul Volcker,” they said.
This was also the case during the pre-Volcker years, when the Fed was led by Arthur Burns and G. William Miller. In July 1973, when the annual CPI rate was hovering near 6% but poised to keep climbing, a Burns-led Fed pushed the fed-funds rate above 10%, FactSet data shows. Policy makers brought interest rates down to 9% for six months, then pushed them back up again to 10% or higher through mid-1974. But the CPI rate didn’t fall back below 6% until the second half of 1976.
Under Miller’s short term from 1978 to 1979, inflation came roaring back until it was in the double digits again. Policy makers returned to pushing rates above 10% again, even before Volcker took the helm.
No one is suggesting the Fed is about to resort to double-digit interest rates right now, particularly when the fed-funds rate target is only between 0.75% and 1% with two more 50-basis-point hikes on the way for June and July. But if a similar stubborn-inflation dynamic plays out this time around, it would likely come as a rude surprise for financial markets, putting equity valuations further at risk.
Economists like those at BofA Securities are expecting the year-over-year CPI rate to fall to 3.3% by year-end. Traders have also been projecting the rate will fall into early next year, to around 5% or lower. And the Fed’s vice chair, Lael Brainard, told CNBC on Thursday that bringing inflation down is the Fed’s No. 1 challenge; she’s looking for a string of lower readings to feel more confident the central bank can get back to its 2% target.
“There are aspects of the historical pattern that are very relevant: Namely, that inflation took a number of years to develop, kept growing, receded, then came back and was hard to get rid of,” said Mace McCain, chief investment officer at San Antonio-based Frost Investment Advisors, which manages $4.7 billion.
“That is also probably true today, we just have to be a little careful about drawing direct comparisons,” McCain said via phone. In the past, the U.S. labor market had stronger labor unions, which he says contributed to the wage-price spiral of the 1970s and 1980s.
For now, his base-case expectation is that annual headline CPI readings will fall toward 4% or 5% by year-end from April’s level of 8.3%, an environment which will still be “very damaging to people’s real earnings.” The next CPI print for May is due on June 10.
Financial markets remained relatively sanguine after Brainard’s remarks. Treasury yields were little changed, with the 10-year rate TMUBMUSD10Y, 2.917% at 2.92% as of Thursday afternoon. Meanwhile, all three major U.S. stock indexes SPX, +1.44% DJIA, +0.89% COMP, +2.32% were moving higher, shrugging off earlier weakness.
If inflation falls at a slower-than-expected pace, BofA Securities strategists said the U.S. dollar and crude oil “would be set to outperform” for the rest of the year. A sharp contraction in Russian oil exports could even trigger a “full-blown 1980’s-style oil crisis and push Brent well above US$150/barrel,” they said in a note.
And in a non-base-case scenario in which inflation stays closer to its current levels into year-end, McCain said he would expect the most damage to be done to 20- TMUBMUSD20Y, 3.302% and 30-year Treasury yields TMUBMUSD30Y, 3.085%, as investors sell off those bonds. “If inflation doesn’t moderate, historic P/E ratio comparisons indicate that the market would need to revalue lower,” he said.