Text: Yan Xiang, Shi Lin
Key conclusions:
The risk of secondary inflation in the United States continues to rise, and the market is once again concerned about the high inflation in the 70s: according to the current trend, the low point of the US CPI this year may be around 2.8%, among which the rise in resources and the resurgence of rents will boost inflation, and the probability that the Fed will not cut interest rates this year is increasing. At present, inflation remains high, which has attracted widespread attention from the market, and high inflation in the 70s has once again entered the limelight. Inflation in the 70s was full of twists and turns, showing a double-top pattern: (1) first inflation (1973-1975): the first inflation began to brew in 1965, began to rise sharply in the second half of 1972, reached a high point at the end of 1974, continued to ease after 1975, and fell to a local minimum (4.9%) by the end of 1976;(2) secondary inflation (1977-1981): US inflation rose again in 1977, reaching a peak of the 70s (14.8%) in early 1980 Inflation continued to decline, returning to below 4% by the end of 1982. From 1973 to 1975, the United States experienced the first wave of high inflation: (1) the first inflation in the 70s was driven by the joint promotion of the supply side and the demand side: the double widening of monetary and fiscal policies in the United States in the late 60s, the decoupling of the dollar from gold in 1971, and the surge in commodity prices caused by the first oil crisis in 1973 jointly led to the first wave of high inflation; (2) the end of the first oil crisis, coupled with the Fed's continuous interest rate hikes, the U.S. economy entered a recession, and the U.S. inflation eased significantly from 1975 to 1976. From 1977 to 1981, high inflation in the United States made a comeback, and it was more serious than the first one: (1) the soaring prices of energy and agricultural products in 1977 under extreme weather, and the second oil crisis that began in 1978 further raised energy prices, coupled with the Fed's lack of strategic determination and decision-making mistakes, and secondary inflation occurred; (2) After Fed Chairman Volcker took office in 1979, he continued to raise interest rates, and the Reagan administration reduced its intervention in enterprises. Stimulated production, inflation in the United States continued to decline after 1980, and returned to below 4% by the end of 1982. In the secondary inflation of the 70s, resources led the rise, and U.S. stocks and U.S. bonds underperformed in the upward inflation phase: (1) In the secondary inflation stage, commodities such as gold and energy led the rise, and U.S. stocks performed poorly, while U.S. bonds continued to weaken during the interest rate hike cycle. (2) For the U.S. stock sub-sectors, the energy and industrial sectors led the rally during the upward inflation phase, while the defensive sectors such as communications and utilities performed poorly, and the excess returns of technology and consumption in the downward inflation phase were once again highlighted. How to look at the current secondary inflation risk: (1) Compared with the 70s, the causes of high inflation in the United States since 2021 are similar: resource prices have skyrocketed under supply-side disturbances, the Federal Reserve has over-issued money, loose liquidity continues, and the US dollar credit margin has been impacted. (2) Resource goods are expected to remain strong, but the oil crisis in 1978 is difficult to reproduce, and the core services with rent as the core will bottom out in 2024H2, which means that it is difficult for the current round of inflation to reach the high point of the 70s, but it is likely to remain above 3%. For the Fed, learning the lessons of the 70s premature rate cuts means that it needs to maintain a hawkish stance in the short term to further curb demand. Risk warning: First, geopolitical risks exceed expectations. Second, the Fed is hawkish. Third, historical experience does not represent the future.
The main body of the report
1 The risk of secondary inflation in the United States continues to rise
At present, the risk of secondary inflation in the United States continues to increase, and the probability that the Fed will not cut interest rates this year increases: (1) The low point of US CPI may be around 2.8%: According to our report "Be Alert to the Risk of the Fed Not Cutting Interest Rates for the Year", according to the current trend, the US CPI will be low or around 2.8% year-on-year, and it is difficult to reach the Fed's 2% target. As of 2024.03, the U.S. CPI is 3.5% year-on-year, even if it is based on the weak assumption of 0.2% month-on-month, it is expected to reach the lowest 2.8% of the year by August-September, and then return to more than 3% under the effect of the base effect; It has a boosting effect on the economy and all types of assets, but the rise in commodity prices and the resurgence of rents may be the pain points of the Fed's inability. Among them, the logic of supply-side constraints behind the rise in resource goods, the impact on US dollar credit, and the tight balance of the U.S. housing market behind the strong rent items. (3) The probability that the Fed will not cut interest rates this year is increasing: the U.S. economy is still resilient, especially the cooling of the job market will take time, and the risk of secondary inflation cannot be underestimated, so the need for the Fed to cut interest rates preventively is declining, and the market is currently expecting a rate cut in September or is still optimistic, and the possibility of continuing to delay or even not cut interest rates throughout the year cannot be ruled out.
Since the epidemic, the trend of inflation in the United States has a certain similarity with that of the 70s. In the 70s, the United States as a whole was in an era of great stagflation, and it showed the characteristics of an M-top. After the first wave of inflation in 1973-1974, it rose sharply again in 1978-1979, and the second inflation peak was much higher than the first. Among them, although there were two oil crises brought about upward pressure on commodity prices, the Fed's premature interest rate cut also played a role. Since the epidemic, the inflation pattern in the United States has a certain similarity with that in the 70s, with inflation in the United States rising sharply since 2021, peaking in June 2022 catalyzed by the Russia-Ukraine conflict, and continuing to decline until June 2023, hovering above 3% so far. At present, the market is generally worried that if the price increase of upstream resources continues to be deduced, the Fed will release the expectation of interest rate cuts prematurely, which may lead to the subsequent US inflation being easy to rise and difficult to fall, and the experience of the second inflation in the United States in the 70s may have a certain reference significance for the current market.
2 The Second Inflation of the 1970s
Inflation in the 70s was full of twists and turns, showing a double-top pattern: (1) the first inflation (1973-1975): the first inflation began to brew in 1965, and inflation began to rise sharply in the second half of 1972, reaching a high point at the end of 1974, continuing to ease after 1975, and falling to a local minimum (4.9%) by the end of 1976 ;(2) Secondary inflation (1977-1981): Inflation in the United States began to rise again in 1977, reaching a peak of 14.8% in the 70s in early 1980 and well above the first high in 1974, and then continued to decline, returning to below 4% by the end of 1982.
2.1 The First Inflation (1973-1975)
The first inflation in the 70s originated from the joint promotion of the supply side and the demand side: (1) In the late 60s, the United States monetary and fiscal policies were broadened, and inflation has risen significantly: since 1965, US President Johnson has put forward a policy program of building a "great society", the core of which is to build a "welfare state" and increase social spending to quell the domestic civil rights movement, on the other hand, with the United States involved in the Vietnam War in 1964, fiscal spending has also risen sharply. In terms of monetary policy, in line with the active fiscal policy, the Federal Reserve has maintained an accommodative tone in monetary policy. Especially after the economic growth declined in the 70s, the Federal Reserve cut interest rates sharply in order to stimulate the economy, which objectively made the liquidity of the United States wider, providing monetary incentives for inflation that began in 73 years; (2) The dollar was decoupled from gold, and the world entered the stage of credit money: In August 1971, the Nixon administration announced the suspension of the obligation to convert the dollar into gold, the Bretton Woods system collapsed, and the United States, Japan, Europe and other countries entered the sovereign credit currency system. (3) Driven by the first oil and energy crisis, commodity prices soared: In the early 70s, global food prices rose sharply under the supply shortage, and the oil crisis that broke out in Q4 of 1973 contributed to the sharp rise in commodity prices.
After the end of the first oil crisis, the U.S. economy entered a recession under the Fed's continuous interest rate hikes, and U.S. inflation eased significantly from 1975 to 1976: (1) After the end of the first oil crisis in March 1974, commodity prices began to peak and fall: taking gasoline as an example, gasoline appreciated by 43.4% year-on-year in May 1974, but then fell sharply, falling to -0.2% in May 1975. (2) Under the Fed's continuous interest rate hikes, the U.S. economy entered a recession stage, and demand was greatly suppressed: in H2 1972, the Federal Reserve began to raise interest rates continuously in response to inflationary pressures, and from 1973 to 1974, with the rapid rise in inflation, the pace of interest rate hikes accelerated significantly. Reflected in the U.S. economy, from 1973Q4 to 1975Q2, the U.S. as a whole was in a recession stage, and the demand side was greatly suppressed, which made the inflationary pressure significantly weakened from 1975.
2.2 The Beginning and End of Secondary Inflation (1977-1981)
In 1975-1976, the United States bid farewell to the first high inflation and experienced a sweet phase of economic recovery and inflation decline, but this characteristic did not last long, and high inflation began to return again in 1977, and the results were more severe than the first inflation. Under the influence of extreme weather, energy and agricultural prices rose sharply again in 1977, kicking off the second inflation. The 1976-1977 winter weather in the United States was extremely cold, which led to a sharp increase in energy prices, including oil and natural gas. At the same time, wellhead prices and over-regulation of the interstate natural gas market dampened developers, which led to a "gas shortage" in the northern United States, which was an importer of natural gas resources in 1976-1977. Similarly, the supply of agricultural products was affected by extreme weather interference, and agricultural prices hit record highs again in the first half of 1977.
The second oil crisis pushed US inflation to new heights. The outbreak of the Islamic Revolution in Iran in 1978 and the cessation of Iran's oil exports from the end of 1978 to the beginning of March 1979 led to a sharp rise in international crude oil prices, known as the second oil crisis. In September 1980, the Iran-Iraq war broke out, and oil production in the two countries came to a standstill, and oil supply was once again tight. In the case of WTI crude oil, the price soared from $14.9 per barrel in August 1977 to $39.5 per barrel in May 1980. Driven by high oil prices, inflation in the United States reached a new high by 1980.
The Fed lacked strategic focus, cut interest rates before inflation completely receded, and did not fully understand the relationship between money and inflation, which limited its monetary policy framework and ultimately made mistakes. Although the high inflation of the 70s was largely due to supply-side disruptions in resource goods, the Fed's internal decision-making errors were also an important reason. On the one hand, Fed officials, represented by then-Fed Chairman Burns, still attribute the rise in inflation to cost-push and structural factors, and do not fully understand the relationship between money and inflation, and still keep an eye on interest rates in monetary policy tools, but are relatively dull to changes in the money supply, which was an important factor in the persistence of high inflation in the 70s. Although the Fed has entered a cycle of interest rate hikes since 1977, M2 remained high year-on-year from 1976 to 1977, and the year-on-year increase in deposit reserves continued until 1978.
On the other hand, the Fed's independence is disrupted by political pressure. According to academic research (Abrams, 2006), in 1971, then-President Richard Nixon pressured then-Fed Chairman Burns to adopt an expansionary monetary policy before the 1972 election. The shift raised suspicion and, as the evidence came out, became a prime example of the Fed's loss of independence. And the failure to blindly cut interest rates when inflation has completely subsided has also become an important reason for the occurrence of secondary inflation. In 1979, the new Federal Reserve Chairman Volcker took office and raised interest rates by storm, and Reaganomic economics reduced corporate intervention and stimulated production, so that inflation in the United States continued to decline after 1980 and returned to below 4% by the end of 1982. From the 1980s to nearly 40 years before the epidemic, there was no high inflation similar to the 70s in the United States, until 2021, when the specter of inflation began to reappear. After the Reagan administration took office, its policy thinking shifted from Keynesianism to neoliberalism and supply-side economics, and it achieved remarkable results. After US President Ronald Reagan came to power in 1981, he shifted to the supply-side school of policy thinking, and the core measure was to implement large-scale tax cuts for enterprises and taxpayers to reduce government intervention in enterprises. His first order was to immediately end oil price controls, a move that boosted the incentives of domestic crude producers, and oil companies significantly increased their investment in domestic oil and gas exploration and production, which played an important role in easing the energy shortage.
After Volcker came to power, he adhered to the monetarist theory, continued to raise the federal funds rate and the inflation rate, and finally succeeded in curbing inflation. After Paul Volcker became chairman of the Federal Reserve in 1979, he led the Fed in formulating new operating procedures that explicitly shifted the Fed's monetary policy target from the federal funds rate to the money supply (M1), and set the total reserves of the commercial banking system in order to continuously raise the policy rate. By December 1986, the US CPI had fallen to 1.1% year-on-year.
2.3 Major asset classes and U.S. stocks in the secondary inflation phase
During the secondary inflation phase of the 70s, commodities such as gold and energy led the rally, while US stocks underperformed, while US bonds continued to weaken during the interest rate hike cycle. From 1975 to 1976, driven by the weakening of inflationary pressures in the United States, the shift of the Federal Reserve from raising interest rates to cutting interest rates, and the month-on-month recovery of the economy, the U.S. market formed a double-bull pattern of stocks and bonds, with U.S. stocks and U.S. corporate bonds rising by 37.8% and 15.7% respectively in 1975, and U.S. stocks and U.S. corporate bonds rising by 26.5% and 18.8% respectively in 1976. However, after the second inflation started again in 1977, commodities such as gold and energy made a comeback, and U.S. stocks generally underperformed commodities in the time period except for 1980, while U.S. bonds were subject to the Fed's continued interest rate hikes + high inflation, and their performance was far worse than that of U.S. stocks. The U.S. once again experienced a two-bull pattern of stocks and bonds, and it was not until after 1982 that U.S. stocks led by a large margin, benefiting from the gradual cooling of inflation, the sharp weakening of policy rates, and the improvement of economic fundamentals, and the performance of U.S. bonds was also strong.
For the U.S. stock sub-industries, the energy and industrial sectors led the rise in the secondary inflation upward stage, the defensive sectors such as communications and utilities performed poorly, and the excess returns of technology and consumption in the downward stage of inflation were highlighted again: (1) In 1977-1979, the secondary inflationary pressure in the United States gradually increased, and the energy item made a comeback again, leading by an absolute advantage in 1978-1979, followed by industry, communications, (2) After Volcker's interest rate hike in 1980 plunged the U.S. economy into recession, market risk appetite was significantly suppressed, led by communications, and although energy prices were still rising, they have weakened sharply in the stock market; (3) Inflation began to accelerate in 1981 + the Fed began to cut interest rates at the end of 1981, and the technology sector led the rally again, and consumption also performed better.
3 How to view the current risk of secondary inflation
Compared with the 70s, the causes of high inflation in the United States since 2021 have similarities: (1) Commodity prices have skyrocketed under supply-side disturbances: The bulk bull market in the 70s was closely related to the two oil crises (1973 and 1979) and the food crisis, while the supply-side disruptions since 2021 are first reflected in the continued supply chain blockages after the epidemic and the intensification of the Russia-Ukraine conflict in 2022. (2) The Fed's over-issuance of money, and loose liquidity is directly interpreted as inflation: The high inflation in the 70s largely stems from the Fed's decision-making mistakes, keeping an eye on the policy interest rate but M2 is mostly at a high level year-on-year, and the high inflation since the epidemic is largely due to the over-issuance of money by global central banks including the Federal Reserve, and the large amount of liquidity directly leads to high inflation; (3) The US dollar credit margin has been impacted, and the premium of resource goods relative to the US dollar is increasing: the background of the 70s is the decoupling of the US dollar from gold, the collapse of the Bretton Woods system, and the world has entered the stage of credit money, and the US dollar has weakened, including gold, energy and other commodities and other types of assets The yield and volatility have increased significantly. One of the reasons for the current rise in resource goods is that the premium of resources relative to the US dollar is increasing in the context of the continuous increase in the US fiscal deficit rate and the lack of constraints. Looking ahead, the probability of reproducing the secondary inflation of the 70s is relatively small, but the inflation center is expected to remain around 3%, inflation is difficult to fall within the year, and it is difficult for the Federal Reserve to cut interest rates: (1) The upward pressure on resources is still there: the rise in resources in the 70s and the current stage of the inflation rebound are important factors, but the second rebound in the 70s is triggered by the second oil crisis caused by geopolitics, although the geopolitical pressure is still there, but the intensity may be difficult to reproduce the 1979 scenario, which means that the high point of secondary inflation is relatively limited. (2) The Fed's rent-centered core services have bottomed out in 2024H2: The core reason for the tight housing and rental market in the United States is that the inventory of housing in the United States is at a historically low level, and at the higher interest rate level, landlords are generally reluctant to sell, which further exacerbates the tension between supply and demand in the housing market. Therefore, even if the Fed continues to raise interest rates, the impact on the housing market may be relatively limited, and the continuous rise in housing prices will drive up rents. If we learn the lesson of premature interest rate cuts in the 70s, it means that the Fed needs to maintain a hawkish stance in the short term to further suppress the demand side, which needs to be continuously observed.
3 Risk Warning
First, geopolitical risks exceed expectations. Second, the Fed is hawkish. Third, historical experience does not represent the future.
This article is from the report "The Past of Secondary Inflation in the United States in the 70s" released by Huafu Securities Research Institute on April 28, 2024.
Analyst:
燕翔， S0210523050003
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