When US inflation began to spike in March 2021, Federal Reserve (“Fed”) Chairman Jerome Powell described the trend as transitory. Eight months later, it showed no sign of slowing.
Since then, the Consumer Price Index (CPI) showed a year-on-year (YoY) increase of 9.1%, the highest since 1981.
Markets are beginning to price in a 1% rate increase at the next Fed meeting, an unprecedented move that could push the US into a recession.
The Biden Administration is urging calm and assuring the US public that the situation can be contained. But should investors be concerned?
What is behind the numbers
As the most commonly used measure of price growth, the CPI measures the price movement in a basket of goods and services (e.g. food, travel, rent) that represent the typical household spending of an urban consumer. Core CPI excludes food and energy, which tend to be more volatile.
Fuel costs increased 11% in June, and nearly 60% YoY, largely due to global problems unconnected to the US economy. Costs have also surged in other categories such as rent and dental care.
Contributing to the price increases are supply chain issues, post-pandemic surges in demand for goods and services, and the Covid stimulus spending.
Unchecked inflation induces workers to demand higher wages, leading employers to continue to hike prices regardless of the fundamentals of supply and demand. Meanwhile, as inflation erodes their purchasing power, consumers become less confident and spend less, leading to reduced economic activity.
Lessons from history
Significant spikes in US inflation have happened before in the post-war era, the early 1970s, and early 1980s. The last time that rapid inflation was tamed by monetary policy was during the so-called “Volcker era.”
Paul Volcker took control of the Fed in 1979, when headline inflation was running at 9%.
He pursued a ruthless strategy of tightening the money supply continually and raising interest rates (which peaked at 19.5% in 1980). The strategy worked. Inflation was controlled by the end of the decade, and a new bull market lasted 18 years.
The US economy had a bumpy ride in between. Inflation continued to climb despite Volcker’s actions, peaking at 14.8% in 1981. Two brief but severe recessions ensued.
Jerome Powell hopes that price stability can be restored without a Volcker-like campaign, and its economic consequences.
Back to today
A recent publication by Larry Summers, former US Secretary of the Treasury, and a group of economists suggested that we may be closer to the peak inflation of the Volcker era than we think.
The methodology for calculating CPI has changed since the 1980s. Home ownership cost, for example, is no longer considered. Adjusting for this change, the 1981 peak would have been 11.4%, not 14.8%.
Source: National Bureau of Economic Research
Also as calculated today, even the harsh Volcker policy would have reduced core inflation by just 4.8%, not 10.6%. This implies that the Fed may need to consider far more austere measures to reduce core inflation from 5.9% to a more manageable 1%.
The Larry Summers report shows how historical data can be interpreted to make widely different predictions. Regardless of historical precedents, any drastic moves by the Fed are bound to affect US consumer demand, employment and the stock market.
 CNBC - https://www.cnbc.com/2021/11/30/powell-says-fed-will-discuss-speeding-up-bond-buying-taper-at-december-meeting.html
 Bureau of Labor Statistics (BLS) - https://www.bls.gov/news.release/cpi.nr0.htm
 Reuters - https://www.reuters.com/markets/us/fed-seen-jacking-interest-rates-further-us-inflation-soars-2022-07-13/
 White House - https://www.whitehouse.gov/briefing-room/statements-releases/2022/07/13/president-biden-statement-on-cpi-inflation-in-june/
 BLS - https://www.bls.gov/news.release/cpi.nr0.htm
 Forbes - https://www.forbes.com/sites/johndobosz/2022/04/25/powells-plan-to-exorcise-inflation--echoes-early-1980s-volcker-crusade/?sh=1ef8f5e420a2
 National Bureau of Economic Research - https://www.nber.org/system/files/working_papers/w30116/w30116.pdf