Why inflation is heading higher over the long term, but probably won't return to 1970s levels


Everyone seems to be preoccupied with rising inflation nowadays. While I agree that inflation will rise over the next 1-3 years, I don’t think it will even reach high-single digit levels. A return to the 1970s’ double-digit inflation is extremely unlikely. In this post we’re going to look at:

  1. Why inflation won’t rise a lot (i.e. to high single-digits).
  2. Why inflation is on the long term rise.


*We’re going to look at headline inflation (including food and energy) and core inflation (excluding food and energy).

Why inflation won’t rise a lot

People who think that inflation will return to 1970s-levels are forgetting a key point: the world has changed. The fundamental conditions that CAUSED double-digit inflation in the 1970s no longer exist.
Commodity price shocks
Inflation in the 1970s was largely driven by commodity price shocks. Commodity prices soared for 2 main reasons:
The commodity price-controls that had kept prices artificially suppressed for decades were lifted. This chart shows what happened to gold when price controls were lifted. Gold is representative of the entire commodities family.

But the second factor was more important: political shocks. OPEC imposed an oil embargo on the U.S. from 1973-1974. Oil prices TRIPLED in a few months because the U.S. was a big net importer of oil. (The U.S. imported 1/3 of its oil consumption).

The same thing happened in 1979-1980. Global oil supply fell 4% due to the Iranian Revolution. And since oil is an inelastic market, relatively small changes in supply/demand cause a much bigger change in the price of oil.

Note: these were 1 time EVENT driven shocks. They were not slowly moving macro trends. Slowly moving macro trends usually lead to long bull markets in oil (e.g. 2002-2008). 1 time EVENT driven shocks lead to a sudden spike in the price of oil.
Commodity price shocks are unlikely 
These MASSIVE historical commodity price shocks are unlikely to repeat in the next few years.
For starters, the U.S. is not on commodity-price controls. Prices are no longer “artificially suppressed”.¬† Commodities trade on free markets.
But more importantly, political shocks are having a smaller and smaller impact on commodity prices. The U.S. is on the path to becoming energy-independent by the early 2020s.
This chart demonstrates how U.S. net energy imports are rapidly falling. This figure will only fall further as U.S. shale production increases (shale is very profitable above $70 per barrel).

In other words, OPEC and foreign nations no longer have the same kind of control over the U.S. economy as they used to have. They can no longer hold the U.S. hostage by jacking up commodity prices and cause widespread economic destruction.
Demographics
Inflation trended higher in the 1960s and 1970s due to changing demographics. Demographics are in reverse today.
U.S. population growth was very high in the 1950s thanks to the post-war Baby Boom, and then slowly trended downwards over the next few decades.

There is usually a lag of 20-30 years between “increases in the population” and “increases in inflation”. This is inherently logical. People rapidly increase their spending in their late-20s and 30s when they’re forming families. A rapid increase in the population (babies) means that spending will rapidly increase in 20-30 years when the babies become adults.
*The more people there are who work, the more they will spend and consume (push consumer prices upwards).
This chart shows the correlation between core-inflation and U.S. birth as a % of the Total Population. Notice how birth leads core CPI by 30 years.

There are no signs that U.S. population growth rate will increase significantly over the next decade.

Why inflation will rise slowly rise over the next decade

With that being said, I do think that inflation will slowly rise over the next decade.
Demographics are changing.
Inflation was continuously suppressed from the 1980s to present because of the demographic deluge of baby boomers (more workers). This was combined with the introduction of women into the workforce, which drove down the relative cost of labor to GDP from the 1970s to the 1990s.

But here’s the interesting point. The velocity of money has fallen consistently over the past 2 decades, coinciding with a decline in the U.S. labor participation rate.

But what if labor participation has bottomed? What if it rises a little over the next decade? If it does, the velocity of money will rise as well, pushing it back towards the long term average. A rising velocity of money suggests that inflation will slowly trend higher over the long run.

There are also anecdotal reasons why inflation is on the long term rise. Globalization and the introduction of cheap Chinese labor have pushed prices for consumer goods down over the past few decades. But prices can’t go down much more – labor costs are rising in developing countries.
This chart demonstrates the rapidly increasing labor cost in Chinese manufacturing. It is a little outdated, so labor costs have risen even further since then.

Conclusion

A return to the 1970s level of double-digit inflation doesn’t seem likely based on what we know today. The 1970s had certain conditions (mainly political) that are unlikely to be repeated because the world is different. A big rise in inflation is highly unlikely without the presence of these political shocks.

3 comments add yours

  1. Your points are so much better articulated than the “experts” and “analysts” I occasionally watch on bloomberg tv.

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