Macro Insights Weekly: Inflation, past and present

Commentary: Inflation, past and present

Rarely has monetary policy imperative switched from extreme dovishness to extreme hawkishness. From markets’ pricing in a depression and never-seen-before official support measures in 2020-21 to deep concerns about inflation in 2022, global markets have lurched from seeing near-permanent hold in policy to expecting several hundred basis points of tightening this year.

What is transpiring is rare, but there are some parallels. One particularly instructive episode is from eight decades ago. The US saw a spike in inflation in the early 1940s as World War II intensified and supply chains faced severe disruption, and then again right after the end of the war as price controls were removed and pent-up consumption demand surged, while the supply side struggled to keep up. The Korean War in the early 1950s also caused a spike in inflation as consumers, remembering the rationing of the early 1940s, rushed to buy and hoard goods. But otherwise the 1950s were characterised by a production boom that allowed supply to keep pace with inflation.

What are the parallels between the inflation spike of the 1940s and present? Firstly, the pandemic caused major disruption to the supply chain and a seismic policy response, akin perhaps only to the war years of the 40s. Secondly, each episode of difficulty for the population was followed by a period of surging pent-up demand. Thirdly, there were sharp changes in output gap and unemployment rate.

The two episodes are not entirely similar; supply chains and markets are far more globalised today, allowing for quicker transmission of shocks. Inflation in the 1940s had to do with all sorts of disruptions, but was not driven by an oil shock. Given the jump in nominal oil prices this year, this is one aspect where the latest jump in inflation has some additional echoes from other episodes (the two oil shocks of the 1970s).

Inflation in the 1940s was accompanied by strong demand boosting policies and war-related disruptions, and by the late 1940s, in a stark parallel to present circumstances, generated vigorous policy response from the US authorities. A series of credit and fiscal tightening measures, deemed excessive by economic historians, pushed the US economy into a recession by the late-1940s, along with outright deflation.

The ongoing energy price shock, so far at least, is much milder than the shocks of the 1970s, when real prices rose by 2-3 times (compare that the 35%yoy increase presently). But the swing in output gap over the last two years has been unprecedented. 1940s teaches us not to panic about inflation, but policy makers don’t have the benefit of hindsight; they will act now.

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