A History of U.S. Inflation

This article was featured in the Georgia Association of Public Pension Trustees’ newsletter.

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For the past 40 years or so, inflation has been more-or-less benign for the average investor – but today inflation is rising, and the Fed is raising rates in an effort to cool the economy. We sat down with Balentine’s Director of Research, Gabe Lembeck, to ask for his insights on today’s high inflation in the context of U.S. History.

What is Inflation?

Inflation in its purest form is an expansion of the money supply in the economy – as Milton Friedman said back in the day: “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Figure 1 shows federal assets back to 1985, and, as you can see, the money supply's been expanding for a while. Most of this was fairly benign until the onset of the coronavirus pandemic in 2020. As you can see in Figure 1,there is a little hockey stick up when the pandemic began, and then it kept going as more and more monetary policy easing was implemented to deal with the stimulus.^[1]

Figure 1. Federal Asset Expansion (1985-Present)

Source: Federal Deposit Insurance Corporation

Note: The shaded areas represent recessions.

How did today’s inflation start?

In Figure 2, you can see the year-over-year expansion in the monetary supply back to 1985. Most years the percent change was between 2%-5%, but during the pandemic, monetary supply growth was anomalously high before coming back down to more normalized growth levels. It is not unexpected that after such a situation you would have a large amount of inflation.

Figure 2. Percent Change in Monetary Supply (1985-Present)  

Source: Federal Deposit Insurance Corporation

How is inflation measured?

There are a few main ways of looking at inflation: the Consumer Price Index (CPI), the Producer Price Index (PPI), and the Personal Consumption Expenditures (PCE). Briefly, the CPI and PPI are measured by the U.S. Bureau of Labor and Statistics. CPI looks at price changes of a fixed basket of goods - let's say on average, consumers buy X percent of milk, Y percent of eggs (Figure 3). The PPI does a similar thing, but rather than looking at final consumer goods, it looks at intermediate goods to see the inflation experienced by producers. The PCE flies under the radar, but it's the one that's the most preferred by the Fed because it's not measured by surveys – it's measured using GDP data through the U.S. Bureau of Economic Analysis. The PCE looks at a floating basket of goods rather than a fixed one because as consumer preferences change, sometimes due to inflation, spending patterns change.

Figure 3. Consumer Price Index (1871-Present)

 Source: St. Louis Federal Reserve

Which Index is the most accurate at identifying inflation?

We believe the PCE identifies inflation more accurately than the other measures because it analyzes a floating measure of goods rather than a fixed one. That said, the CPI, PPI, and PCE typically all trend in the same direction, so you would not get a situation where they’re providing contradictory information. While CPI is most often used by the financial media and investment writers, the PCE informs a lot of the Fed decisions.

What does CPI^[2]tell us about inflation over the last 150 years?

We can divide the last 150 years into regimes, segmented by color in Figure 4.

 Figure 4. Year-over-year change in CPI (1872-Present)  

Source: U.S. Bureau of Labor Statistics and Balentine

First Regime: In the first regime, there was a lot of inflation volatility – you would get sharp inflation and then sharp deflation. Imagine you're going to the grocery store and the price of eggs is up 10%, then the next month it's down 10%, then the next month it’s down another 10%, and the following month it’s up another 10%. This is the type of situation we had for approximately 50 years. There were strong inflationary and deflationary forces during this period. The industrial revolution, as with any productivity progress, was very deflationary. On the other hand, World War I followed the historical template of wars, and it was sharply inflationary — as seen in the sharp increase inflation during 1914-1918 

Second Regime: The roaring twenties began after World War I, which led to a lot of speculation, and high inflation continued. In the 1930s, during the Great Depression, there was still high inflation and massive deflation, but the volatility was much lower. In addition, there is a bit more stability during this period due to the introduction of the Federal Reserve, which implemented policies that led to some inflation and deflation stability.

Third Regime: Coming out of World War II, there was a big disinflationary boom for about 15 years, where we define disinflation as positive inflation, but at a low rate.

Fourth Regime: This disinflationary boom primed us for the great inflation from the late 1960s to the early 1980s. There was a high inflation rate but with low volatility. In other words, the inflation rate went up, but unlike the high inflation seen prior to the Great Depression, it was consistent and not volatile at all.

Fifth Regime: This eventually led to the 40-year regime we would posit ended in 2021, which was characterized by low inflation and low inflation volatility – like the 15-year run we saw after the end of WWII. Volatility is important because when it is unknown, it leads to a lot of concerns. For example: it’s hard to run a business when inflation is high, but at least you know what you’re dealing with. On the other hand, with inflation volatility, it’s harder to effectively run a business.

Sixth Regime: We just entered a sixth regime – and we don't know if the volatility will be high or low.

How long will we experience high inflation?

A lot of people tend to think that this inflation is not going to last too long, but we would posit that it’s going to potentially last longer than people think. Present-day, we typically look at prices and data beginning with WWII or the Great Depression — before then, the data is very noisy and a lot of it isn’t as relevant anymore because of the efficiencies in the economy. Below, we’ve plotted CPI measured within these two time frames (Figures 5 and 6) and ran time series – or found the trend lines. You’ll note that prices were above the trend line after 1983 and then fell below the trendline in 2008, where they sit today. As a result, we will likely have a period of above-average inflation to catch back up to the trend. So, while it’s frustrating to see higher prices now, the reality is prices probably should have been rising higher all along during this period, and now we’re catching up.

Figure 5. Consumer Price Index (1950-Present)

Source: U.S. Bureau of Labor Statistics and Balentine

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Figure 6. Consumer Price Index (1933-Present)

Source: U.S. Bureau of Labor Statistics and Balentine

How long will it take us to catch up?

This could happen quickly, or it can happen slowly over time– and though much of the timing will be determined by the Fed’s policies, as well as economic experience, we expect there to be some similarities to the inflationary period during the 1970s. This is not to suggest that we think it will last between 10-15 years or that rates will be consistently above 5% and routinely above 10%; rather we think that elements of inflation will remain stickier than is generally consensus. Such an experience will likely not be as painful or wealth-eroding as that of the 1970s, but it does mean that investors, consumers, and workers may have to adjust expectations to account for what is likely to be a bumpier road ahead for some time.

[1] Stimulus refers to fiscal policy – government spending. Easing is monetary policy – when the central bankputs more money in the economy.  

[2] Because CPI is the most often cited, we decided to utilize it for our analysis.

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