Ode to Inflation

The future course of inflation is one of the most pressing issues facing investors today. Many have been lulled into a sense that inflation or its evil twin deflation have been wrestled to the ground and are yesterday’s problem. After all, as the chart shows (box C), since 1982 U.S. inflation has ranged between 0% and 6%, and, for most of that period, it has not exceeded 4%.

Are we being too complacent?

History might be telling us that yes, we are being too complacent and that over the past 275 years, there have been two other periods of at least forty years, when inflation and deflation were boxed in, in comparatively benign conditions and both of these were followed by explosive inflation, followed by equally explosive deflation (see boxes A and B). What is noteworthy about these incidents is the speed with which benign inflation soared to 36% in 1800 and 25% in 1917. Both incidents were followed by massive deflation.

So, what triggered these inflation spikes, and are there any common factors that might pertain to today?

The answer seems to be YES.

In 1800, Britain had been at war with France for twenty years and the cost of maintaining its own forces while subsidizing those of its European allies had brought Britain to the verge of bankruptcy. Britain’s economy couldn’t keep pace with the amount of money spent on arms, causing shortages and higher prices for many goods. The national debt at that time was estimated to amount to 200% of GDP.

In 1917, Britain’s economy was in tatters. In addition to funding its own war efforts, Britain was providing financial assistance to both France and Russia. This resulted in the British national debt skyrocketing out of control as the national debt rose more than 1,000% over 5 years. This amounted to 135% of GDP.

In 2020, the USA has been at war in the Middle East for nineteen years and the national debt has risen consistently through that time. In comparing 1917 to 2020, one cannot ignore the impact of a pandemic:  the Spanish Flu in 1917 and COVID 19 in 2020. The US national debt has risen from $6 trillion in 1999 to $26 trillion by March of 2020. This represents an increase in debt to GDP from 58% to 136% in twenty years.

As mentioned above, the suddenness with which inflation took off after these two lengthy periods of benign inflation is striking. Could it happen again?

Today’s central bankers have far more control over the economy and have managed to contain boom/bust cycles better than their predecessors. We believe that information flows and modern analytic tools, provide today’s decision-makers with better information and thus the ability to better manage any inflation outbreak that might ensue.  Therefore, we would expect that any replication of events in 1800 and 1917, will be contained but it is equally clear that all portfolio managers need to be alert to the potential of a moderate to serious inflation spike over the foreseeable future.

¹ https://www.usinflationcalculator.com/inflation/historical-inflation-rates/
“UK Inflation Calculator: GBP from 1751 to 2020.” Official Inflation Data, Alioth Finance, 3 Nov. 2020, https://www.officialdata.org/UK-inflation.
USA Debt to GDP source data FRED: The Federal Reserve Bank of St.Louis

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