One Hundred Years of Separation: The Inflation of 1919 and COVID-19

Abstract

Over the past nine months, I published a series of research papers highlighting the striking similarities between the current burst of inflation in the wake of the COVID-19 pandemic and the inflation that Americans experienced 100 years ago when World War I and the Great Influenza abruptly ended. Both events are explainable as monetary phenomena (as Milton Friedman brilliantly argued is always the case), but severe supply chain disruptions also amplified the effects and complicated the responses.

On March 16, 2022 the FOMC commenced its endgame when it raised interest rates by 25 basis points and announced aggressive plans to reduce its massive balance sheet. Expectations are that tightening will continue until inflation is convincingly extinguished. The challenge, however, is that monetary policy is a blunt instrument, and when it is applied to counteract extreme economic conditions, the risk of overshooting the target increases substantially. For this reason, there is a high risk that the current tightening cycle will eventually produce a reversal of economic growth (i.e. a recession) and a reversal of price increases (i.e. deflation). However, given improved communication with market participants and a policy of gradualism, it seems unlikely that the reversal will be as dramatic as it was in 1921.

The next 12 months will almost certainly be volatile, as investors will repeatedly recalibrate their expectations in response to monetary policy announcements and the corresponding economic and market responses. It will be tempting to observe the similarities between the 1919 Inflation and COVID-19 Inflation and attempt to time the market. This is a risky proposition for long-term investors, as there are many unpredictable factors that could easily alter the current path. In fact, the unexpected war in Ukraine is an excellent example of one such factor. Prior to the outbreak of hostilities, it appeared that the Federal Reserve would act even more aggressively to tame inflation. It is conceivable that additional unforeseeable circumstances will arise that will further alter monetary policy in unexpected ways. Therefore, as always, the most prudent approach for the long-term investor is to stick to a target allocation that matches their long-term objectives, use market volatility to rebalance to that target, and avoid engaging in tactical decisions that seek to profit from short-term events that are fickle and unpredictable.

Keywords: FOMC, Federal Reserve, 1919, Great Influenza, COVID-19, Inflation

JEL Classification: E31, E32, E44, E52, E58