With the rise in US inflation reaching a 40-year high of 6.4% YoY, there has been increasing concerns of stagflation, similar to the 1970s. While we see some similarities, we do not think this is the same boat. Firstly, the US government is expected to embark on a gradual fiscal consolidation. Secondly, the Fed has changed course to signal its commitment to tackle inflationary pressures. And thirdly, long-term inflationary expectations remain relatively anchored. Nevertheless, the on-going military conflict between Russia and Ukraine adds a layer of complication which may lead to further rise in long-term inflation expectation, increasing the dreaded risk of stagflation.

Introduction Déjà vu. Following the rise in US inflation reaching a 40-year high of 6.4% YoY (PCE – price consumption expenditure), there have been increasing concerns that stagflation could be looming, similar to what was experienced during the 1970s. In this report, we evaluate at the similarities and differences between “The Me Decade” and now.

The Great Inflation. 1965-1980 was characterised as the Great Inflation or stagflation period. Prior to that period, inflation averaged 1.3% YoY. However, inflation began inching upwards from 1965 and reached a peak of 11.6% YoY in March 1980 (Figure #1). In 1965, inflation was 1.4% and unemployment rate was 4.5%, but by 1980, both had raised to 10.8% and 7.2% respectively – the phenomenon which most economists have broadly termed “stagflation”.

Fiscal policy

Then: Stimulative fiscal policy to support growth. When President Lyndon came to office in 1963-1969, he made it a priority to create a Great Society and eliminate poverty in America. This led to reduction in corporate and personal income tax and significant expansion in government spending. In addition, the US economy also increased defence spending due to the Vietnam War. As a consequence, over the next decade of 1970-1980, fiscal deficit averaged at a high of -2.0% of GDP, significantly greater than previous decades (1950-1969: -0.6% of GDP). This led to higher spending in the economy, which also contributed to inflationary pressures.

Now: We do not think it is similar to the 1970s as the US government is expected to narrow fiscal deficit following the expiration of Covid-19 measures. Given the Covid-19 crisis, the US government released a USD1.9tr emergency plan that led to the surge in fiscal deficit (average 2020-2021: -13.5% of GDP vs 2019: - 4.6% of GDP). Going forward, expiring Covid-19 relief is expected to cause annual deficits to decline from USD2.8tr (-12.4% of GDP) in 2021 to USD1.2tr (-4.5% of GDP) in 2023.

Monetary policy

Then: Fed tolerated higher inflation to pursue full employment. Despite the rise in inflation from 1965, the Fed did not respond aggressively to ease price pressures. In fact, some Fed officials and prominent economists generally believed expansionary monetary policy should continue to propel the economy further toward full employment. In addition, while the Fed did raise interest rates, it was tepid and inconsistent due in part to the FOMC Board’s division and lack of coherent strategy. It was only after FOMC Chairman Volcker maintained a forceful and difficult policy stance from 1979-1987, that the public began to expect lower and less volatile inflation.

Now: After one year of tolerating higher inflation to pursue maximum employment, the Fed has voiced its intention to prioritise inflation. In Jan 2021, the Fed revised the monetary policy framework to emphasise the goal of maximum employment. As a result, the Fed kept interest rate at record low levels and was willing to tolerate inflation surpassing its 2.0% goal in the short-term. Nevertheless, starting Dec 2021, the Fed changed track and communicated its intention to raise rates to counter the increasing threat of inflation. Eventually, the Fed hiked interest rate by +25bps in Mar 2022 and signalled its commitment to raise rates further. Currently, there is increasing consensus that the Fed may be behind the curve as the gap between the real rate and core inflation is the highest since the 1970s (Figure #2).

Inflation expectations

Then: Persistent inflation led to de-anchoring of long-run inflation expectations. The 1970-1978 period saw a decade of high government spending, Fed’s tolerance to high inflation and failed income management attempts to restore price stability (i.e. President Nixon’s wage price controls that artificially held down inflation temporarily). By the end of the decade, inflationary psychology had become well entrenched – University of Michigan’s 1-year inflation expectation survey showed consumers’ inflation expectation had risen to a peak of 10.4% in Jan 1980.

Now: At this point, long-run inflation expectations remain anchored, but risk seeing steady rise due to the Russia-Ukraine conflict’s impact on commodity prices. Rising inflationary pressures have pushed up near-term inflation expectations. University of Michigan 1-year inflation expectation stands at 4.9% YoY (Figure #3). In the next 5 years, participants’ opinions were more varied as 5-year breakeven inflation rate is at 3.0% (Figure #4) while the 5-year forward inflation expectation rate is 2.3% (Figure #5). Over a longer-time frame, participants anticipate inflation will moderate from current high prices (Figure #6). However, there are risks that the Russia-Ukraine conflict will keep inflationary pressures higher and cause a steady rise in its expectations (Figure #7).

Energy supply shocks

Then: Economy suffered two supply shocks. The first crisis was an Arab oil embargo that began in Oct 1973. During this period, oil prices rose by 301.7% from USD2.90/brl to USD11.65/brl. Subsequently, the economy experienced a second oil shock in 1978, sparked by the Iranian revolution. Oil prices rose rapidly again, more than doubling between Apr 1979 and Apr 1980.

Now: While we did experience two supply shocks (Covid-19 and current Russia Ukraine conflict), the jump in oil prices have been smaller in magnitude vs the 70s. Since the successful introduction of vaccine against Covid-19 in Dec 2020, Brent oil price rose by 113.0% from USD47.42 to reach USD100.99 in Feb 2022. Shortly after that, oil price rose further by 26.7% to reach a peak of USD127.98 in Mar 2022 when the Russia-Ukraine conflict erupted. (Figure #8).

Conclusion

While we do not think the US is going to see a repeat of 1970s stagflation episode due to the factors above, the on-going Russia-Ukraine conflict does add a layer of complexity, which increases stagflationary risks. Prolonged higher energy prices on top of an already strained supply chain and strong underlying economic growth may push inflationary expectations higher. We think this may pressure central banks to continue signalling their strong commitment to avoid de-anchoring of inflation expectations. Over time, tighter monetary policy is expected to cause growth slowdown or risk an outright recession. While Malaysia is relatively insulated at this point due to its status as a commodity exporter, the risk of a prolonged war or escalated sanctions could lead to heightened uncertainty of global economic prospects and tighter financial conditions, which could eventually weaken international demand and FDI prospects. For now, we maintain our GDP of 5.5% with downside risk and 25bps OPR hike in 4Q22.

Source: Hong Leong Investment Bank Research - 7 Apr 2022