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The 1970s Inflation Crisis and Market Collapse

In the 1970s, the U.S. experienced three major inflationary waves, with inflation soaring as high as 15%. Each wave triggered significant stock market declines, with U.S. equities falling by over 20% each time. Fast forward to today, and inflation is once again a growing concern. The recent surge in inflation, the highest since the 1970s, led to a 25% drop in stocks in 2022. Now, with the Trump administration's proposed policies, some economists warn that this could be the beginning of another prolonged inflationary cycle, much like the one seen in the 1970s.

IMF Warnings on Inflationary Risks

The International Monetary Fund (IMF) has been raising concerns about this potential scenario. They argue that Trump’s policies—such as increased tariffs and stricter immigration rules—could reignite inflation. Higher tariffs would make imported goods more expensive, and businesses are unlikely to absorb these costs; instead, they will likely pass them on to consumers. Meanwhile, tighter immigration laws could lead to labor shortages, forcing companies to raise wages to attract workers. The result? Increased business costs, rising wages, and ultimately, higher inflation.

The Federal Reserve’s Role in Inflation

However, some argue that the IMF is placing too much emphasis on Trump’s policies and not enough on the role of the Federal Reserve, the U.S. central bank. The Fed plays a crucial role in managing inflation, and today, its approach differs significantly from the past. Looking at the early 1970s—a period notorious for high inflation—the Fed responded by aggressively raising interest rates as inflation climbed from around 2% to over 12% between 1972 and 1974. However, when inflation showed signs of slowing, the Fed quickly cut rates. In 1975 and 1976, interest rates remained below the inflation rate—a key factor that many academics believe set the stage for the devastating inflationary wave that followed, ultimately pushing inflation to 18%.

The Danger of Negative Real Interest Rates

A similar situation unfolded in 2022 when the Fed’s benchmark interest rate remained lower than inflation, preceding another sharp spike in prices. This phenomenon, known as negative real interest rates, encourages borrowing and stimulates economic activity, which can further fuel inflation. In fact, research from the IMF has found that negative interest rate policies have historically been effective in loosening financial conditions, but they also come with the risk of triggering inflationary surges.

Will History Repeat Itself?

With these historical patterns in mind, the key question remains: Are we on the verge of another prolonged inflationary cycle, or will the Fed take decisive action to prevent history from repeating itself?

Central Banks and the Use of Negative Real Interest Rates Many central banks around the world have used negative real interest rates as a strategy to stimulate inflation when it has been too low. Countries like Denmark, Japan, and Sweden have implemented this approach to bring inflation back to healthier levels. However, the situation in the U.S. today is quite different.

The Impact of Positive Real Interest Rates Currently, the Federal Reserve's benchmark interest rate stands at 4.5%, while inflation sits at 2.9%. This means that interest rates are higher than inflation, a situation known as positive real interest rates—the opposite of what occurred in the early 1970s and in 2022. Positive real interest rates encourage saving over borrowing, which slows economic activity and helps keep inflation in check.

Paul Volcker’s Strategy to Tackle Inflation We have seen this strategy work before. Paul Volcker, who served as Federal Reserve Chairman during the high-inflation period of the late 1970s and early 1980s, implemented a policy of maintaining interest rates above the inflation rate. By consistently keeping the Fed’s benchmark rate higher than inflation, Volcker was able to steadily bring inflation under control. This contrasts sharply with the early 1970s, when low interest rates fueled persistent inflation.

The Federal Reserve’s Position Today Today's monetary policy appears to align more closely with Volcker’s approach rather than the inflationary policies of the early 1970s. Even if the IMF's warnings about Trump's economic policies leading to higher inflation are accurate, the Federal Reserve seems well-positioned to counteract these risks through its commitment to maintaining positive real interest rates.

The Housing Market’s Role in Inflation One of the clearest indicators of the Federal Reserve’s influence on inflation is the housing market. Housing plays a major role in inflation calculations, accounting for approximately 45% of the Consumer Price Index (CPI), making it the largest single component of inflation data. Given that housing is one of the biggest expenses for most households, changes in home prices and rent directly impact consumer spending and overall inflation trends.

Shifting Spending Patterns and the Post-Pandemic Housing Market

Following the 2020 pandemic, home prices surged significantly, contributing to rising inflation. However, since the second quarter of 2022—when real interest rates turned positive—the housing market has cooled down considerably. In fact, median home prices have been declining over the past year, signaling downward pressure on inflation.

The Cooling Rental Market and Its Impact on Inflation

It's not just home prices that have been adjusting—rent prices have also been on the decline. Data from the Cleveland Fed, which tracks rent prices for new tenants, shows that rental rates for newly signed leases have fallen to levels last seen during the financial crisis. This is a key indicator of future inflation trends, as new tenant rent data typically leads official CPI rent inflation by about nine months. The current downturn in new rental prices suggests that rent inflation will continue to decline, reinforcing broader disinflationary trends.

The Federal Reserve's Influence on Inflation

While Trump's policies will undoubtedly shape economic conditions, investors should not overlook the Federal Reserve's role in managing inflation. The ongoing cooling in housing and rental markets highlights the Fed’s influence in counteracting inflationary pressures.

Disclaimer: I want to make it clear that I am not a financial advisor, and nothing I say is intended to be a recommendation to buy or sell any financial instrument. Additionally, it's important to remember that there are no guarantees or certainties in trading or investing, and you should never invest money that you can't afford to lose.

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