Inflation similarities between the 2000s and the 1970s

“even though we have not seen the volatility of the 70’s we are certainly traveling in the same direction.”

In the 70s, gold spiked to over $800, Inflation rates were over 14%, OPEC limited the supply of Oil, there were wars in the Middle East and the U.S. economy was a wreck. In the 2000s, Gold has doubled from $250 and ounce to over $500, inflation has doubled from 2% in 2002 to over 4% in 2005, Oil supply is maxed out, the decade began with a recession… is there any chance that we are returning to the 70s?

Recently I was asked, whether I saw any similarities between the 1970’s and the current decade. And that got me to thinking. If you remember the 70’s culminated in a double digit blow off in inflation similar to the stock blow off which ended in 2000.

In the 70’s we had Oil coming out of an era where the US controlled the supply and the price and entering an era where OPEC was in control.

In the 70’s, war in the Middle-East had a drastic effect on the price of oil. Syria and Egypt attacked Israel in 1973 resulting in a backlash of support from the US and other Western countries. In retaliation several Arab Oil exporters imposed the “Arab Oil Embargo”. This resulted in a drastic increase in the price of oil and showed the Arabs the power they now had. By the end of 1974 the price of oil had quadrupled. 

In response to foreign price increases the US instituted price controls on domestically produced oil. This ill advised price control policy caused U.S. producers to receive less than the world price for oil. So naturally they cut back on costs like exploration etc.

A better policy by the government would have been to encourage US producers to flood the market with oil and take up the slack from the reduced supply from overseas but the fear was that we were “running out of oil”.

Prior to the Arab Oil Embargo, inflation had already been heating up in the U.S. but the price of Oil hadn’t kept up. From 1958 to 1970 prices were pegged at $3.00 a barrel but in inflation adjusted terms crude prices were declining from roughly $16 a barrel in today’s dollars to about $13. This was made worse for international producers because the Dollar was falling at the same time so they were losing not only because of inflation but also because of currency exchange rates.

Starting the 70’s we had a recession and stagflation (inflation combined with a stagnant economy).

In a nutshell the 70’s began with a poor economy, high inflation, and the problem was made worse by war and Oil supply problems and compounded by wage and price controls.

Then for the next twenty years the price of oil fell in real terms until it was no longer profitable to search for new oil and once again we hear talk of “running out of oil”. So how did we get here?

The late 90s started with a recession in the Asian economies as they stumbled and both production and consumption fell. This put downward pressure on demand for oil at the same time former communist countries ramped up production as they became more capitalistic. This increased the supply of goods and depressed prices even further. It also put an effective cap on U.S. inflation.

Falling demand and rising supply is the recipe for lower prices.

Going into 2000 the government pumped up the money supply in preparation for a Y2K event that never happened. Combined with low priced labor from China, this increased capital had no where to go except the stock market, so rather than seeing price inflation we had “stock inflation.”

When the market crashed it effectively eliminated massive chunks of excess capital. So we entered the new millennium with much lower levels of inflation than in the 70s and more overseas competition resulting is greater supply.

The market crash ushered in a very shallow recession as the government continued to stimulate the economy through lower interest rates. Massive refinancing of high interest home loans for lower interest ones allowed consumers to continue to spend.

Just as the 70s began with under priced oil, an unusual set of circumstances resulted in under priced Oil again in 2000. Supply had steadily increased through the late 90s due to OPEC quota increases and increased production from Russia. By 2001 increased supply met decreased demand for oil because of the Asian recession.

In normal circumstances OPEC would have curtailed supply to keep the price firm. However, it was politically impossible for them to do so because of the events of 9/11, so prices fell drastically sheltering the U.S. from some of the effects of the stock market crash.

In 2002 a strike by Venezuelan Oil workers eliminated the excess supply and solved OPEC’s problem and this was followed by the war in Iraq which further reduced supply. Now as the economies of Asia heat up again the demand for oil has increased but supply has not been able to keep up.

In 2002 worldwide excess oil capacity stood at over 6 million barrels per day but by 2005 excess capacity has fallen to under 1 million barrels of oil per day.

Combined with the short supply and the increased demand for Oil from Asia, we also have the U.S. government spending unprecedented billions of dollars on hurricane repairs and a war in Iraq. These are all inflationary factors.

We have to remember that inflation is primarily a monetary phenomenon. Increased money supply results in increased inflation. Up until recently the government has been able to export our inflation by selling bonds to foreign governments.

Recently the combined increase in inflation, the falling dollar and falling interest rates has made those sales less advantageous to foreigners. Fewer bond sales to foreigners results in even more inflation.

From the above chart  we can see that inflation in the 70’s was much more volatile than in the new millennium but that the linear regression trend line appears to coincide fairly well with the current trend. So even though we have not seen the volatility of the 70’s we are certainly traveling in the same direction. If this trend continues we could see double digit inflation ten years from now and with a little volatility thrown in we could see it much sooner.