Summary
• The oil price surge is comparable to that of the 1970s, but the US economy is now much less exposed to energy prices.
• While the pandemic caused a supply shock, this is likely almost over.
• Largely because of weaker worker bargaining power, the risk of a 1970s style wage-price spiral is much lower. Rather, households’ real income is falling, weakening demand and helping contain inflation.
• The ongoing fiscal retrenchment will further weaken demand and slow inflation.
Market Implications
• Curve flattening
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Summary
- The oil price surge is comparable to that of the 1970s, but the US economy is now much less exposed to energy prices.
- While the pandemic caused a supply shock, this is likely almost over.
- Largely because of weaker worker bargaining power, the risk of a 1970s style wage-price spiral is much lower. Rather, households’ real income is falling, weakening demand and helping contain inflation.
- The ongoing fiscal retrenchment will further weaken demand and slow inflation.
Market Implications
- Curve flattening
Current Supply Shocks Shallower and Shorter Term Than the 1970s Oil Shocks
The recent oil price jumps and Fed concerns of persisting ‘supply bottlenecks’ have triggered higher inflation fears, possibly based on a perceived analogy with the 1970s. I think such fears are unwarranted for three broad reasons. First, energy prices and inflation have decoupled since the mid-1980s (Chart 1).
Second, the supply shocks hitting the US economy now are shallower and shorter term than those of the 1970s. True, the YoY increase in energy prices hitting the US is comparable to the 1970s oil shocks (Chart 1). However, the US economy is now much less energy dependent and no longer a net importer of energy (Chart 2). Indeed, the post-GFC increases in oil prices were of a similar magnitude to the current one. Yet core inflation remained stubbornly under 2%.
This time the US must also deal with a COVID-induced supply shock. But unlike the energy shocks that lasted through the 1970s, the COVID shock will likely be much shorter. With high immunizations and good policies, Scandinavian countries are already back to the new normal. The US is bound to follow suit – if not through immunizations, then through immunity acquired from infections. That said, supply chains now are much longer than in the 1970s, and global normalization could take a couple of years, so residual supply bottlenecks will remain.
Inflation Dynamics Are More Stable Than in the 1970s
Third, inflation dynamics have changed considerably since the 1970s. Then, the oil price surge triggered a wage-price spiral because workers had enough market power to demand wage increases that offset the increased cost of living. Workers only relented when the Volker recession of the early 1980s brought a large increase in unemployment.
Decades of globalization, labour-saving technological progress, and weakening workers’ rights followed the recession. Consequently, worker bargaining power is much weaker now than during the 1970s, as shown by a lower share of labour income and a secular decline in the ratio of real wages to productivity.
The pandemic hit just when labour market tightening had let workers stabilize their income share. But this was a cyclical improvement; the structural factors weakening labour bargaining power were unchanged. Consequently, workers have been unable to obtain high enough wage increases to maintain real wages, and household real income has been falling. This decline in demand is helping contain the pandemic-induced price pressures, as the recent sequential slowdown in the core CPI shows.
The inflation pickup largely reflects extraordinarily expansionary fiscal policy: countries with larger budget deficits have seen more of a spike in inflation. The US is an outlier both for budget deficit and inflation. But like the monetary policy tightening of the early 1980s, fiscal policy is seeing unprecedented tightening, which will likely bring down inflation – and the recovery.
Market Consequences
The Fed has been normalizing policy into a supply shock, an unusually restrictive policy move (we are now very far from FAIT…). In a 2015 speech, then-Chair Janet Yellen stated that ‘Because temporary shifts in the rate of change of import prices or other transitory shocks have no permanent influence on expectations, they have only a transitory effect on inflation. As a result, the central bank can “look through” such short-run inflationary disturbances in setting monetary policy’. In this context, the ongoing curve steepening is surprising. I expect it will reverse once disinflation gathers pace.
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Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)