With commodity prices soaring, money supply growth exploding, and government spending surging, there is a palpable fear of a return to 1970s-style inflation. I get it. I remember those times. Bell bottoms, long hair, aviator glasses, and disco music were popular. (Although I confess to embracing the fashions of the era, I was never a disco fan.)

It wasn’t all frivolous, though. In fact, it was a tumultuous time both socially and economically. The era opened with the Kent State shootings, unfolded into Watergate and President Richard Nixon’s resignation, hit a crescendo with the fall of Saigon, and ended with the Iranian hostage crisis. In the middle, there was an economically crippling oil price spike, a deep recession, and high inflation. It’s the memory of high inflation that seems to strike a nerve with investors.

What causes inflation?

Inflation results when demand exceeds supply in an economy. Economists use the “output gap” to capture this phenomenon. When the economy grows faster than its ability to provide goods and services demanded by consumers, prices rise. When the economy grows more slowly than its potential growth rate, prices tend to fall. Factors that affect an economy’s growth rate include the supply of labor and the productivity of those workers.

Due to the pandemic, there was a huge widening of the output gap last year, but the economy’s rapid rebound has caused the gap to narrow but not yet fully close. With more fiscal stimulus on the way, it’s likely that the gap will close later this year and potentially move above trend in 2022, signaling inflation risk.

Gross domestic product growth is picking up, but the output gap isn’t closed yet

Although the difference between actual gross domestic product, or GDP, and nominal potential GDP has narrowed to $312 billion, the gap isn’t completely closed yet.]

Source: U.S. Bureau of Economic Analysis, Gross Domestic Product (GDP) and Nominal Potential Gross Domestic Product (NGDPPOT). Quarterly data as of Q1-2021.