Will a new year take us back to the 1970s?

It may be almost 2024, but is the economy heading back to the 1970s? Economists have, admittedly, been asking this ever since inflation started rising over two years ago –  but there are reasons to think the comparison could endure even though price growth is on the decline for now. 

The surface-level parallels with the 1970s remain undeniable: we have seen an energy price shock (and the threat of more to come), soaring inflation and economic stagnation all set against a noisy background of industrial action and geopolitical unrest. 

With rates on hold, the question of when to make the first cuts is also starting to weigh on the Bank of England (BoE). Rate-setter Catherine Mann warned earlier this autumn that in the absence of a crystal ball, “a mistake” by rate-setters is all but inevitable: cut too late and wipe out growth and unemployment, but cut too soon and risk fuelling a 1970s-style second wave of inflation. Could economic history repeat itself next year? 

Another round of shocks?

If the 1970s taught us anything, it's that high inflation is not easy to resolve. The period saw what Deutsche Bank analysts call a series of “seemingly transitory inflationary shocks” coalescing to fuel an extended period of high inflation – as the chart shows. 

Deutsche Bank analysts Henry Allen and Cassidy Ainsworth-Grace warn that “inflation is still above target in every G7 country, and the 1970s showed how unexpected shocks could rapidly send inflation higher once again”. 

The Bank of England (BoE) remains highly attuned to the risk of another supply side shock, and stressed the “upside risks to inflation from energy prices given events in the Middle East” in its November monetary policy report. This too has uncomfortable echoes of the 1970s, when twin oil price spikes struck against a high-inflation backdrop.

Although the rate of inflation plummeted last month to 4.6 per cent, it is expected to fall at a far slower rate over the months ahead. November’s huge deceleration was largely driven by a mechanical adjustment – as the impact of last year’s energy price increases rolled out of calculations, the headline inflation rate dropped. 

The problem is that this won’t be repeated. According to the BoE's latest forecasts, inflation will take until the end of 2025 to return to 2 per cent. If so, we face a difficult wait of almost two years for inflation to get back to target – made all the more tense by the scope for further energy price spikes.

The good news is that our economies are less energy intensive than they were in the 1970s – and less vulnerable to energy prices as a result. According to calculations by Allen and Ainsworth-Grace, US energy intensity has fallen by almost two-thirds relative to 50 years ago, while (in contrast to the 1970s) the US is now a net energy exporter. European countries remain more vulnerable thanks to their reliance on energy imports, but – so far, at least – conflict in the Middle East has had a limited impact on oil prices.

Energy prices aren’t the only issue

But as our economies have evolved, so have the commodities that we rely on. The US Department for Energy rates lithium and nickel as exposed to ‘critical supply risks’, while copper and uranium have ‘near critical status’. According to a report from Dutch bank ING, 80 per cent of aluminium inventory on the London Metal Exchange was Russian material earlier this autumn – and this all increases our vulnerability to supply shocks. Our 1 December cover feature next week explores the topic of energy security in more detail.

It is worth stressing that ‘green metals’ don’t have the same capacity as oil prices to drive an inflation surge, but they could make it harder to return to target. ING economists point out that the semiconductor shortage in 2021 pushed up demand for used cars, which was by itself enough to add more than a percentage point to US consumer price index (CPI) inflation. Analysts said that the episode showed that “disruption for key products is capable of generating sizeable upward inflation moves”. 

And 2024 heralds another 1970s throwback: a strong El Niño. El Niño triggers weather changes and increases the risk of natural disasters across huge swathes of the globe. As the chart shows, the early 1970s saw one of the strongest such events in decades – and we have just entered another one. 

The US Climate Prediction Centre has confirmed that this El Niño has now met the threshold for a “strong” event, and forecasters see a 62 per cent chance of it lasting until June next year. If a strong event triggers higher food prices, the deck could be stacked towards another supply side inflation shock. 

Another winter of discontent? 

Strikes are also giving the 2020s a very 1970s feel – although a closer look at the data suggests that their impact should be more restrained. It might not feel like it, but the number of working days lost to strike action in 2023 has been relatively low by the standards of historical peaks: around 4mn in the twelve months to September, against 30mn in 1979. Unionisation levels are also far lower today than it was in the 1970s, as the table shows. 

But this doesn’t mean that we can dismiss fears of a 1970s-style wage-price spiral entirely. Since the pandemic, inactivity levels have soared, leaving the UK economy with a tight labour market. At 7.7 per cent, regular pay growth remains significantly higher than inflation, and BoE rate-setters are worried about the impact of wage pressures on the inflation rate. 

The impact of higher interest rates will weigh on the economy over the next few months, and the labour market should ‘cool’ as more people lose their jobs. But higher wage pressures could be with us for the longer term. Economists at ING think that the past few years have given us “a flavour of how the ageing populations we see in many developed economies could actually be inflationary”. After all, if there are fewer working-age people, employees will have the bargaining power to push for pay rises – unionised or not. 

Can the Bank of England help? 

Although some of the forces hitting the UK economy feel reminiscent of the past, policymakers are in a vastly different position today thanks to central bank independence. 

Since the 1990s, rate-setters have had the freedom to set monetary policy to meet the inflation target, and operate free from political influence. Deutsche Bank’s Allen and Ainsworth-Grace point out that this marks a substantial change to the 1970s, when central bankers “were under political pressure (both explicit and implicit in nature) to support growth by avoiding restrictive policy”. 

As a result, the BoE’s Mann is among those who reject direct comparisons with 50 years ago: although the period saw large supply shocks, it was also an era free of inflation targeting, with no independent monetary policy committee and less well integrated trade and financial systems. Mann argues that because the impact of supply-side shocks depends so heavily on all of these factors, “we should pay attention to these periods while being careful about the conclusions that we can and cannot draw”.

Central bank independence has also had an important impact on inflation expectations. If people are confident that inflation will return to the 2 per cent target, they should be less sensitive to spikes in the price level caused by supply side shocks. In theory, this should translate to less aggressive wage and price setting, and a lower chance of high inflation becoming embedded in the economy. 

Will policymakers cut too soon? 

And for much of the past two years, inflation expectations were remarkably well anchored. Despite inflation rising to double digits in the UK, inflation expectations have never moved anywhere near as high. Deutsche Bank’s Allen and Ainsworth-Grace say “this has made the task of central banks much easier, and reduced the need for more aggressive tightening”. In the 1970s – and in the absence of an inflation target – households expected long-run inflation to hover around 7 per cent. 

But there is still no room for complacency. According to the BoE’s preferred market measure, five-year inflation expectations are elevated, at 4 per cent. The Bank’s most recent household survey suggested that households still expect inflation to be 2.8 per cent in two years’ time – and 2.9 per cent in five. Rate-setters are conscious that if firms and households don’t believe that price growth is falling quickly, they won’t factor the decline into their price and wage demands. High inflation expectations can all too easily feed into the actual inflation rate. 

Assuming we return to target by the end of 2025 (the BoE has been too optimistic before), inflation will have spent four years above 2 per cent. Allen and Ainsworth-Grace think that it is “increasingly difficult to imagine that long-term expectations will repeatedly stay lower than actual inflation” if the situation persists for much longer than that. 

Tough decisions 

This creates a difficult backdrop for rate-setters debating when to cut interest rates. Because interest rates work with a lag of 18-24 months, it is very difficult to fine-tune monetary policy. Keeping rates too high for too long risks hurting growth and triggering a surge in unemployment. But cut rates too soon, and policymakers foster the perfect backdrop for an inflation rebound.

As a result, a further supply side shock could easily derail progress. ING economists think that “there are good reasons to expect inflation to be both structurally higher and more volatile over the next decade”. Thanks to central bank independence, this means that the same could well be true to interest rates, too. We haven’t gone back to the 1970s, but the cheap borrowing and low inflation of the 2010s feels a world away.