Four Lessons We Can Learn From The Last 100 Inflation Bouts

Of all the factors that have been driving markets over the past few years, one’s arguably been the most important this year: inflation. Previously brushed off as a short-term blip, a cacophony of issues catapulted it to levels we haven’t seen for decades. Namely, a war between Russia and Ukraine, supply chain disruptions, substantial government interventions, and constrained labor markets, all of which fueled a serious imbalance between demand and supply. Now, inflation’s far from its peak, but still nowhere near where central banks want it to be – and that means it can still upend your portfolio’s returns. Here’s what history tells us is likely to happen next.

What happened in past inflation surges?

The International Monetary Fund (IMF) set out to get a grip on potential inflation trajectories and economic twists. It dove deep into the archives to do that, analyzing 100 inflation jolts across 56 countries over the last five decades. Interestingly, over half of the hiccups were tied to the oil upheavals between 1973 and 1979, a period that bears a striking resemblance to today’s situation. At that time, the world was hit by two oil crises (one triggered by an OPEC embargo, one by the Iranian revolution), political turmoil, and weather-driven supply disruptions – and all that after a period of supportive monetary and fiscal policies. Put together, that combination sent inflation to the double digits.

Headline inflation (blue) and core inflation (red) in the US. Source: Bureau of labor statistics.

The IMF’s findings are well worth paying attention to. Understanding the broader economic landscape and strategies used during past inflation spikes can indicate patterns that may repeat themselves. For example, the time it took for inflation to chill out, the policy plays that worked well, and whether successful inflation-fighting methods always mean trading off economic growth and the job market’s health.

Let’s dive into the IMF’s takeaways:

Inflation has a habit of sticking around, even if it was sparked by a fleeting external event.

Inflation is often initially lit up by an unexpected event like a war, embargo, or supply snag. Problem is, even when that triggering event starts to normalize, the resulting higher inflation doesn’t tend to dissipate. During the oil crisis between 1973 and 1979, over half of the related inflation episodes took more than five years to settle down. And looking at the 100 inflation episodes as a whole, even those stemming from different triggers like a demand spike or major currency shifts, only 60% were tamed within a five-year span. What’s more, the remaining 40% or so still took upwards of 3 years on average to resolve. To put it bluntly, it’s wishful thinking to label inflation as "short-lived", even when it’s sparked by an external hiccup.

Inflation's "false dawns" are common.

Around 90% of cases the IMF studied saw significant drops in inflation within three years from the first shock, only for price rises to then pick up pace again. And it’s true, "base effects" – when price changes are potentially exaggerated or minimized because the earlier comparison point had unusually high or low numbers – might have influenced this. That said, the IMF did find that the main culprit of these double-whammy spikes was central banks and governments relaxing their monetary and fiscal policies too early.

Сountries that resolved inflation applied stricter monetary policies, controlled wage growth, and limited currency devaluation.

The IMF examined the policies of different countries during the 1973 to 1979 oil shocks. The ones that successfully cooled down inflation tended to lean into tighter monetary policies, like raising interest rates aggressively, keeping themhigher for longer, supporting their exchange rates to prevent them from falling, and moderating wage increases. The research also hinted that countries with histories of more robust fiscal stances and previously stable inflation were more equipped to manage inflationary shocks.

Countries that successfully battled inflation were left with a bruised economy, but it rebounded in the long term.

More aggressive inflation-fighting policies often bring about immediate economic setbacks, including a slowdown in growth and a rise in unemployment. But history shows that this short-term discomfort paves the way for long-term stability and prosperity. So while rigorous policies can be a bitter pill to swallow, it’s a proven formula for sustained economic health.

What does that mean for today’s climate?

The first two findings – that inflation tends to hang around for a long time and that false dawns are common – are a warning against running a victory lap too soon. If history’s any guide, you shouldn’t expect inflation to return to the Federal Reserve’s 2% target anytime soon – despite plenty of investors banking on exactly that.

The last two takeaways – that stricter policies were required to tame inflation and that they were better for the economy in the long term – are a cautionary tale for central banks, warning of the dangers of pivoting too early. If they heed the warning, they’ll likely keep rates higher for longer and possibly brace for a recession in the short term. After all, a tough stance could be just what’s needed for a robust, long-term economic revival.

So what’s the opportunity?

History doesn't always repeat itself, of course, but it's probably wise to make sure your portfolio can handle an extended period of higher inflation. Consider diversifying into commodities, like industrial metals and energy that’ll do well if the economy thrives, and gold that holds up if the economy doesn’t. Real estate and a bit of bitcoin might also be smart additions. If inflation sticks around, you can expect higher interest rates for longer, so be cautious when dealing with rate-sensitive areas like high-risk tech, utilities, or consumer discretionaries. Instead, you could lean into healthcare, consumer staples, and energy. Finally, the looming threats of a recession and market dip mean cash reserves are important: they won’t just lower your losses, but will also equip you with cash you can use on any decent opportunities that present themselves.