2022 Economic Forecast

With commodity prices, money supply growth and government spending all surging, there is a palpable fear of a return to 1970s-style inflation. You may remember these tumultuous times well. There were crippling oil prices, a deep recession and high inflation. Are these concerns valid or are they potentially over-blown? 
 
What Causes Inflation?
 
Whether it is the 1970s or the 2020s, the causes for inflation are generally the same. Inflation results when demand exceeds supply in an economy. The technical term for this phenomenon is called “output gap”. Prices rise when the economy grows faster than its ability to provide goods and services demanded by consumers. Prices tend to fall when the economy grows more slowly than its potential growth rate.
 
The chart “Output Gap” compares actual GDP against potential GDP. The latter is a theoretical construct that estimates the value of the output that the U.S. economy would have produced if labor and capital had been applied at their maximum sustainable rates. The gap between the two GDP measures represents the output gap. 
 
Due to the pandemic, there was a huge widening of the output gap in 2020. The economy’s rapid rebound in 2021, due to a strong monetary and fiscal policy response, has caused the gap to narrow. As the general inflation theory predicts, there has been a recent surge in inflation in 2021.

A Short History of Modern Inflation
 
During the first half of the 20th century, inflation was usually associated with wars. This caused shortages of goods and price spikes. The post-war periods were generally followed by deflation as supply caught up with demand. In fact, there were more years of deflation than inflation. It wasn’t until the late 1960s and 1970s that inflation became a long-lasting phenomenon. See chart “U.S. Inflation History” for details. It’s often thought that spiking oil prices and excessive government spending were the leading causes of inflation, during the 1970s era. There was a more to it than that.

During the first half of the 1960s, inflation averaged only 1.1%. However, in 1965, the U.S. increased its spending on the war in Vietnam. As with most wars, demand for industrial goods rose, pushing up prices. At the same time, there was more money in the hands of consumers, who benefitted from higher spending on social programs. By 1969, consumer price inflation was more than 5%. In response, the Federal Reserve (Fed) raised interest rates. This sent the economy into recession. Inflation declined.
 
Inflation Was a Policy Choice In the 1970s
 
When Nixon took office, he was eager to see the economy rebound. He replaced long-serving Fed Chairman Martin with Arthur Burns in 1970. At the same time, the dollar was under pressure due to expanding trade deficits.

Major trading partners (mostly France) were demanding gold in place of currency. In 1971, Nixon severed the dollar’s last ties to the gold standard. This ended the Bretton Woods agreement, allowing the dollar to float freely. It fell by about 15% over the next few years, pushing up import prices.
 
The expansionary spending policies of the 1960s continued, as did the ramped-up spending on the war in Vietnam. Increased government spending fueled increased demand. There were no offsetting tax hikes or spending cuts in other programs. Consequently, demand exceeded supply in the economy for several years and inflation moved up. It was running at 6% in 1970.
 
Rising tensions in the Middle East led to an oil embargo in 1973, sending oil prices up and the economy down. Although it hit double-digit levels of 11% in both 1974 and 1979, inflation averaged 7.1% during the decade. Nixon imposed wage and price controls. This only contributed to a dismal combination of pent-up demand, weak growth and inflation. That’s when the term “stagflation” became prominent.
 
A key contributing factor to inflation was the way monetary policy was conducted. Tapes from the Nixon era indicate that the president pressured Fed Chairman Burns to keep interest rates low despite rising inflation. Fearing he would be blamed for another recession and rising unemployment, Burns gave in to the pressure. He judged inflation as the lesser of two evils. In doing so, the Burns Fed allowed inflation to rise.
 
That turned out to be a bad decision. He’s now remembered as the Fed chairman who caved to political pressure instead of the one who avoided a recession.

When Paul Volcker was appointed chairman of the Fed by President Jimmy Carter in 1979, the Fed made its move to squash inflation. This took a heavy toll on the economy.
 
 Different Era, Same Choice?

There are some similarities to today. Easy monetary policy and increased government spending are spurring strong demand amid shortages of goods. Pandemic relief payments and economic reopening have sent consumer spending up sharply. In 2021, the Fed appears to be prepared to let demand exceed supply without reacting to the output gap.
 
The Fed has made the choice to let inflation rise today. After a lengthy review of its policies over the past few decades, it concluded that it had focused too much on inflation. This has limited growth in the economy, jobs and incomes for many workers.

All of this was before the COVID-19 crisis hit. Faced with the deflationary impact of the pandemic, the Fed believed it had room to allow inflation to rise. This is the primary reason investors are worried about inflation.
 
There Are Significant Differences Between Today and the 1970s
 
Significant differences between the economy today and in the 1970s suggest inflation is not likely to return to those high levels:
 
1. Demographics have changed 

The chart “Ratio of Young vs Middle-Aged Workers” below provides a useful way to envision the impact of demographic changes on the economy. As you can see, the ratio is considerably lower today than in the 1970s. In those days, baby boomers were entering their prime working and spending years. Demand for everything from cars to housing rose. This put upward pressure on inflation. The ratio began to decline in the early 1990s as baby boomers transitioned to their saving years. It bottomed out in about 2010.

Today it’s the millennials—a bigger generation than the baby boomers in numbers—who have entered their spending years. Predictably, household formation is increasing and demand for goods and services is rising. Until recently, the expected boost to growth from the millennials has been dampened by the double whammy of the financial and COVID-19 crises.

Although the ratio hit its low around 2010 and is rising, it isn’t likely to have the impact on the economy that the baby boomer generation did. While there appears to be a sustainable wave of demand taking place, it’s not as big as the tsunami that hit in the 1970s.

2. Globalization May Be Slowing, But It Hasn’t Stopped

The U.S. is still a relatively closed economy, with only about 15% of goods and services consumed coming from abroad (Statista.com). However, that compares to only 4% in the 1970s. Moreover, the composition of imports has changed. Despite all the talk about “re-shoring” and the imposition of tariffs, most of the imports to the U.S. are goods with the prices set in a far more open and competitive global market than in the past.
 
On the wage side, the opening of Eastern Europe and China’s emergence into the global economy have combined to increase the supply of labor which has dampened growth in wages in the U.S.
 
The 2020s Fed Is Beginning To Take Action
 
Today’s Fed is has signaled a return to higher interest rates. It is also beginning to tighten monetary policy that has kept markets flying since it intervened in early 2020.
 
This could be a good thing, if it beats back inflation without derailing the economic recovery. But removing support also inevitably cools the markets as investors move money around searching for the best performing assets.
 
Financial markets now expect the Fed to raise its key interest rate at least three times in 2022 and to start to shrink its balance sheet as soon as this spring. It has reduced the level of its bond-buying already. Fed policymakers will meet again soon to decide on their next steps and market strategists will be watching.
 
Low interest rates made certain sectors especially appealing, foremost among them are tech stocks. This sector has taken a big hit over the past weeks. Take the Nasdaq 100 index as an example. It is made up of 101 equity securities issued by the largest non-financial companies listed on the Nasdaq stock market.
 
During the second week of January 2022, it lost 7.5%, which is the second-worst week since March 2021. Since the beginning of 2022, the index has already dropped by 12%. It is getting close to its worst monthly performance since the financial crisis of 2008. Just as a reminder: In 2021, the Nasdaq 100 rose by 26%, in 2020 it grew by 48%, and in 2019, it grew by almost 38%. 
 
The current market correction is solely due to the Fed’s announcement to raise interest rates in 2022. Many investors are now shifting to the bond market, where rates are rising sharply and prices for existing low-yield bonds are falling quickly.
 
What Should Investors Do?
 
Investors should look for alternatives beyond stock, bonds and mutual funds.

Deposits in savings accounts or classic CDs are not likely to provide any significant returns in 2022. While the rates of bonds are rising and current yields are approaching 2%, the real return is still likely be negative in 2022 after inflation is factored in.
 
We encourage you to look at the concept of First Trust Deed Lending.

Here at Safeguard Capital Partners, our clients hold a mortgage on investment property of their choosing. This mortgage is secured by a first lien position on the property. Just like with the set up of your IRA LLC or Solo 401(k), Safeguard makes sure the paperwork is completed correctly and monthly loan payments are processed properly.