World War 2, M2 and 2020s vision

Over the course of the 1940s the price of a Cadillac sedan soared from $1,745 to $3,497 by 1949, part of a broader surge in prices that came about soon after the US helped secure victory in the second world war. By the time the 1950s came along, however, inflation had fallen back to under 2 per cent.

The Atlanta Fed, in a fascinating research note published this month, uncovers the cause of these short lived price pressures, which serve as a useful guide to the nature of the rise in costs we’re seeing right now.

Prices began to tick up in 1946. probably with rises in the cost of cars and other consumer durables — goods which had not been made during the war years, when productive capacity was devoted to manufacturing of military equipment. Partly as a result of those goods shortages, savings had soared once the US entered the war in 1941. The removal of price controls — and the restarting of production lines after victory was declared in 1945 — led to the unleashing of a wave of pent-up demand (as well as giving a sense of what rationed goods had been trading for on the black market). At its peak, inflation hit 20 per cent.

At 4.2 per cent, US inflation in nowhere near as high today. Nor is it likely to scale those heights again anytime soon. But we are seeing price pressures of a similar type emerge as lockdown restrictions are eased. As FT Alphaville reported last week, rises in automobile prices (in this case those for used cars) are triggering alarm. While the causes of that particular surge are primarily driven by supply-side factors — such as the semiconductor shortage — there are also concerns on the demand side. Notably that governments’ aggressive fiscal response will unleash a wave of pent-up demand.

Some say the staggering rise in the M2 measure of money — which includes some savings deposits in addition to central bank reserves, currency, and time deposits, and which has been primarily driven by the nature of governments’ stimulus — as evidence that we are about to see the return of inflation.

From the St Louis Fed’s website:

Of course, we saw that same rise in government spending during the war years too.

So why didn’t it last more than a couple of years? The paper puts the surge down to a rise in the velocity of money — that is, the speed at which transactions are made, which serves as a proxy for demand. When war ended, people hit the shops. But that spending spree didn’t last. Nor did expectations of inflation become entrenched. The result of that, plus a cut in government spending, was that velocity, together with inflation, soon fell back to where it had been during the conflict:

At the Treasury, deficits swiftly became surpluses when the conflict concluded. Money growth suddenly stopped in 1946 as the need to finance the government ceased. Thus, the increase in prices that year was the direct effect of a swift increase in money velocity. Eventually, the jump in prices further contributed to the stabilisation in the government finances as it diluted part of its sizeable debt burden. Indeed, about 40 per cent of the government’s real debt burden was deflated away by 1948.

Although Fed officials expressed some concern about the inflation outburst, they took little action at first, discontinuing [control of the yield curve for US Treasuries] only in mid-1947. Thereafter, the Fed implemented a series of contractionary policies. These policies mostly involved an increase in reserve requirements and the discount rate. The joint contractionary monetary and fiscal stance culminated in the 1949 recession, with inflation stabilising again back at 2 per cent. The recession was, however, mild and short, and it was followed by robust economic growth and rapid improvement in general living conditions.

One factor that may have contributed to the quick reversal of inflation was that the public never expected an inflationary spiral like they did in the 1970s, and they considered the spike in inflation as temporary. The post-Depression deflationary bias remained in place.

So will we see the same trend this time?

This is certainly what the Federal Reserve expects to happen, saying any inflation is likely to prove “transitory”. And there are certainly plenty of parallels between that era and this one. But the past never repeats itself entirely.

For what it’s worth, we think it will may take longer for some of the supply constraints we’re seeing now to ease, which will exacerbate price pressures. We’re also not totally convinced that people expect inflation to fall back quickly — even though the Fed has said time and again this is what it expects to happen. At the same time, even though savings have increased dramatically, we’re not convinced we’ll see people splash out to the degree that they did after World War Two. The pandemic has reshaped the economic landscape. Our suspicion is that, as stimulus is removed, bankruptcies will rise and job losses will result. They’re the sort of conditions in which people like to set some money aside.

To draw your own conclusion, read the paper in full. It’s relatively short, but provides a far deeper understanding of the mechanisms that drive inflation than pretty much everything else we’ve read on the topic of late. Once you do, we’d appreciate your thoughts in the usual place.