Burns became concerned about inflation in the winters of 1972 and 1973. Inflation had more than doubled to 8.8% in 1973. It would rise to 12 percent later in the decade. Inflation had reached 14% by 1980.
What was the duration of the big inflation?
The Great Inflation was the defining macroeconomic event of the twentieth century’s second half. After the roughly two decades it lasted, the worldwide monetary system built during World War II was abandoned, four economic recessions occurred, two catastrophic energy shortages occurred, and wage and price restrictions were implemented for the first time in peacetime. It was “the worst failure of American macroeconomic policy in the postwar century,” according to one eminent economist (Siegel 1994).
However, that failure ushered in a paradigm shift in macroeconomic theory and, ultimately, the laws that now govern the Federal Reserve and other central banks across the world. If the Great Inflation was the result of a major blunder in American macroeconomic policy, its defeat should be celebrated.
Forensics of the Great Inflation
Inflation was a bit over 1% per year in 1964. It had been in the area for the last six years. Inflation began to rise in the mid-1960s, reaching a high of more than 14% in 1980. In the second half of the 1980s, it had dropped to an average of barely 3.5 percent.
While economists dispute the relative importance of the causes that have spurred and sustained inflation for more than a decade, there is little disagreement about where it comes from. The actions of the Federal Reserve, which allowed for an excessive expansion in the quantity of money, were at the root of the Great Inflation.
It would be helpful to describe the story in three distinct but related parts to comprehend this phase of particularly terrible policy, particularly monetary policy. This is a kind of forensic examination into the motive, means, and opportunity for the Great Inflation to happen.
The Motive: The Phillips Curve and the Pursuit of Full Employment
The first section of the story, the motivation behind the Great Inflation, takes place in the immediate aftermath of the Great Depression, a period in macroeconomic theory and policy that was similarly momentous. Following World War II, Congress focused on programs that it anticipated would foster better economic stability. The Employment Act of 1946 was the most prominent of the new legislation. The act, among other things, stated that the federal government’s role is to “advance maximum employment, production, and purchasing power” and called for more coordination between fiscal and monetary policy. 1 The Federal Reserve’s current twin mandate to “maintain long-run expansion of the monetary and credit aggregates…in order to achieve effectively the goals of maximum employment, stable prices, and moderate long-term interest rates” is based on this legislation (Steelman 2011).
The orthodoxy that guided policy in the postwar era was Keynesian stabilization policy, which was driven in part by the painful memory of the unprecedented high unemployment in the United States and around the world during the 1930s. The fundamental focus of these policies was the regulation of aggregate expenditure (demand) through the fiscal authority’s spending and taxation policies, as well as the central bank’s monetary policies. The notion that monetary policy can and should be used to manage aggregate spending and stabilize economic activity remains a widely held belief that governs the Federal Reserve’s and other central banks’ operations today. However, one crucial and incorrect assumption in the implementation of stabilization policy in the 1960s and 1970s was that unemployment and inflation had a stable, exploitable relationship. In particular, it was widely assumed that permanently lower unemployment rates could be “purchased” with somewhat higher inflation rates.
The idea that the “Phillips curve” indicated a longer-term trade-off between unemployment, which was very destructive to economic well-being, and inflation, which was sometimes seen as more of a nuisance, was an appealing assumption for policymakers who sought to enforce the Employment Act’s requirements.
2
But the Phillips curve’s stability was a dangerous assumption, as economists Edmund Phelps (1967) and Milton Friedman (1968) cautioned. “If the statical’optimum’ is chosen,” Phelps says, “it is logical to assume that participants in product and labor markets will learn to expect inflation…and that, as a result of their rational, anticipatory behavior, the Phillips Curve will progressively shift upward…” Friedman (1968) and Phelps (1967). In other words, the authorities’ desired trade-off between reduced unemployment and higher inflation would almost certainly be a false bargain, requiring ever higher inflation to maintain.
The Means: The Collapse of Bretton Woods
If the Federal Reserve’s policies were well-anchored, chasing the Phillips curve in search of lower unemployment would not have been possible. Through the Bretton Woods agreement in the 1960s, the US dollar was tied if shakily to gold. As a result, the collapse of the Bretton Woods system and the severance of the US dollar from its last link to gold play a part in the story of the Great Inflation.
During World War II, the world’s industrial nations agreed to a worldwide monetary system, which they thought would promote global trade and offer more economic stability and peace. The Bretton Woods system, hammered out by forty-four nations in New Hampshire in July 1944, established a fixed rate of exchange between the world’s currencies and the US dollar, with the latter linked to gold.3
The Bretton Woods system, on the other hand, had a number of faults in its implementation, the most serious of which was the attempt to maintain constant parity across world currencies, which was incompatible with their domestic economic goals. Many countries were pursuing monetary policies that claimed to move up the Phillips curve, resulting in a more favorable unemployment-inflation nexus.
The US dollar faced an additional challenge as the world’s reserve currency. The need for US dollar reserves expanded in tandem with global trade. For a period, an expanding balance of payments deficit met the demand for US dollars, and foreign central banks accumulated ever-increasing dollar reserves. The amount of dollar reserves held overseas eventually exceeded the US gold stock, meaning that the US could not sustain total convertibility at the current gold pricea fact that foreign governments and currency speculators were quick to note.
As inflation rose in the second half of the 1960s, more US dollars were changed to gold, and in the summer of 1971, President Richard Nixon put a stop to foreign central banks exchanging dollars for gold. The short-lived Smithsonian Agreement attempted to save the global monetary system during the next two years, but the new arrangement performed no better than Bretton Woods and quickly fell apart. The worldwide monetary system that had existed since World War II had come to an end.
Most of the world’s currencies, including the US dollar, were now entirely unanchored after the last link to gold was destroyed. Except during times of global crisis, this was the first time in history that the industrialized world’s currencies were based on an irredeemable paper money standard.
The Opportunity: Fiscal Imbalances, Energy Shortages, and Bad Data
The US economy was in a state of flux throughout the late 1960s and early 1970s. At a time when the US economic situation was already stressed by the Vietnam War, President Lyndon B. Johnson’s Great Society Act ushered in large spending programs across a broad range of social initiatives. The monetary policy was complicated by the developing budgetary imbalances.
The Federal Reserve used a “even-keel” policy approach to avoid monetary policy actions that would conflict with the Treasury’s funding plans. In practice, this meant that the central bank would not change policy and would maintain interest rates at their current levels during the time between the announcement of a Treasury issuance and its market sale. Treasury difficulties were rare under normal circumstances, and the Fed’s even-keeled policies didn’t obstruct monetary policy implementation considerably. The Federal Reserve’s adherence to the even-keel principle, however, became progressively limited as debt difficulties became more prominent (Meltzer 2005).
The periodic energy crises, which raised oil prices and stifled US GDP, were a more disruptive force. The first crisis was a five-month-long Arab oil embargo that began in October 1973. Crude oil prices quadrupled at this time, reaching a plateau that lasted until 1979, when the Iranian revolution triggered a second energy crisis. The price of oil tripled during the second crisis.
In the 1970s, economists and policymakers began to classify increases in aggregate prices into various inflation kinds. Macroeconomic policy, particularly monetary policy, had a direct influence on “demand-pull” inflation. It was caused by policies that resulted in expenditure levels that were higher than what the economy could produce without pushing the economy beyond its normal productive capacity and requiring the use of more expensive resources. However, supply interruptions, particularly in the food and energy industries, might push inflation higher (Gordon 1975). 4 This “cost-push” inflation was also passed on to consumers in the form of higher retail prices.
Inflation driven by the growing price of oil was mainly beyond the control of monetary policy, according to the central bank. However, the increase in unemployment that occurred as a result of the increase in oil prices was not.
The Federal Reserve accommodated huge and rising budget imbalances and leaned against the headwinds created by energy costs, motivated by a duty to generate full employment with little or no anchor for reserve management. These policies hastened the money supply expansion and increased overall prices without reducing unemployment.
Policymakers were also hampered by faulty data (or, at the very least, a lack of understanding of the facts). Looking back at the data available to policymakers in the run-up to and during the Great Inflation, economist Athanasios Orphanides found that the real-time estimate of potential output was significantly overstated, while the estimate of the unemployment rate consistent with full employment was significantly understated. To put it another way, officials were probably underestimating the inflationary effects of their measures as well. In reality, they couldn’t continue on their current policy path without rising inflation (Orphanides 1997; Orphanides 2002).
To make matters worse, the Phillips curve began to fluctuate, indicating that the Federal Reserve’s policy actions were being influenced by its stability.
From High Inflation to Inflation TargetingThe Conquest of US Inflation
Friedman and Phelps were correct. The previously stable inflation-unemployment trade-off has become unstable. Policymakers’ power to regulate any “real” variable was fleeting. This included the unemployment rate, which fluctuated about its “natural” level. The trade-off that policymakers were hoping to take advantage of didn’t exist.
As businesses and families began to appreciate, if not anticipate, rising prices, any trade-off between inflation and unemployment became a less favorable trade-off until both inflation and unemployment reached unacceptably high levels. This became known as the “stagflationary age.” When this narrative began in 1964, inflation was at 1% and unemployment was at 5%. Inflation would be over 12% and unemployment would be over 7% ten years later. Inflation was near 14.5 percent in the summer of 1980, while unemployment was over 7.5 percent.
Officials at the Federal Reserve were not ignorant to the escalating inflation, and they were fully aware of the dual mandate, which required monetary policy to be calibrated to achieve full employment and price stability. Indeed, the Full Employment and Balanced Growth Act, more generally known as the Humphrey-Hawkins Act after the bill’s authors, re-codified the Employment Act of 1946 in 1978. Humphrey-Hawkins tasked the Federal Reserve with pursuing full employment and price stability, as well as requiring the central bank to set growth targets for several monetary aggregates and submit a semiannual Monetary Policy Report to Congress. 5 When full employment and inflation collided, however, the employment part of the mandate appeared to have the upper hand. Full employment was the foremost objective in the minds of the people and the government, if not also at the Federal Reserve, as Fed Chairman Arthur Burns would later declare (Meltzer 2005). However, there was a general consensus that confronting the inflation problem head-on would be too costly to the economy and jobs.
Attempts to reduce inflation without the costly side effect of increasing unemployment had been made in the past. Between 1971 and 1974, the Nixon government implemented wage and price controls in three stages. These measures only delayed the rise in prices for a short time while aggravating shortages, particularly in food and energy. The Ford administration did not fare any better. Following his declaration of inflation as “enemy number one,” President Gerald Ford initiated the Whip Inflation Now (WIN) initiative in 1974, which included voluntary steps to encourage increased thrift. It was a colossal flop.
By the late 1970s, the public had come to anticipate monetary policy to be inflationary. They were also becoming increasingly dissatisfied with inflation. In the latter half of the 1970s, survey after survey revealed a deterioration in popular confidence in the economy and government policy. Inflation was frequently singled out as a particular scourge. Since 1965, interest rates have appeared to be on the rise, and as the 1970s drew to a conclusion, they jumped even higher. Business investment stagnated, productivity fell, and the country’s trade balance with the rest of the globe worsened during this time. Inflation was largely seen as either a substantial contributing factor or the primary cause of the economic downturn.
However, once the country was in the midst of unacceptably high inflation and unemployment, officials were confronted with a difficult choice. Combating high unemployment would almost surely drive inflation even higher, while combating inflation would almost certainly cause unemployment to rise much more.
Paul Volcker, formerly of the Federal Reserve Bank of New York, was elected chairman of the Federal Reserve Board in 1979. Year-over-year inflation was above 11 percent when he assumed office in August, and national unemployment was slightly under 6 percent. By this time, it was widely understood that lowering inflation necessitated tighter control over the pace of increase of reserves in particular, as well as broad money in general. As mandated by the Humphrey-Hawkins Act, the Federal Open Market Committee (FOMC) had already began setting targets for monetary aggregates. However, it was evident that with the new chairman, attitude was shifting and that greater measures to restrict the expansion of the money supply were needed. The FOMC announced in October 1979 that instead of using the fed funds rate as a policy tool, it would target reserve growth.
Fighting inflation was now considered as important to meet both of the dual mandate’s goals, even if it temporarily disrupted economic activity and resulted in a greater rate of unemployment. “My core idea is that over time we have no choice but to deal with the inflationary situation since inflation and the unemployment rate go together,” Volcker declared in early 1980. Isn’t that what the 1970s taught us?” (Meltzer, 1034, 2009).
While not perfect, better control of reserve and money expansion over time resulted in a desired slowdown of inflation. The establishment of credit limits in early 1980, as well as the Monetary Control Act, aided this stricter reserve management. Interest rates surged, decreased for a short time, and then spiked again in 1980. Between January and July, lending activity decreased, unemployment increased, and the economy experienced a temporary recession. Even as the economy improved in the second half of 1980, inflation declined but remained high.
The Volcker Fed, on the other hand, kept up the pressure on rising inflation by raising interest rates and slowing reserve growth. In July 1981, the economy suffered another recession, this time more severe and long-lasting, lasting until November 1982. Unemployment peaked at over 11%, but inflation continued to fall, and by the conclusion of the recession, year-over-year inflation had dropped below 5%. As the Fed’s commitment to low inflation gained traction, unemployment fell and the economy entered a period of steady growth and stability. The Great Inflation had come to an end.
Macroeconomic theory had undergone a metamorphosis by this time, influenced in large part by the economic lessons of the day. In macroeconomic models, the importance of public expectations in the interaction between economic policy and economic performance has become standard. The need of time-consistent policy choicespolicies that do not sacrifice long-term prosperity for short-term gainsas well as policy credibility became widely recognized as essential for excellent macroeconomic outcomes.
Today’s central banks recognize that price stability is critical to sound monetary policy, and several, like the Federal Reserve, have set specific numerical inflation targets. These numerical inflation targets have reinstated an anchor to monetary policy to the extent that they are credible. As a result, they have improved the transparency of monetary policy decisions and reduced uncertainty, both of which are now recognized as critical preconditions for achieving long-term growth and maximum employment.
What caused inflation in the 1970s?
- Rapid inflation occurs when the prices of goods and services in an economy grow rapidly, reducing savings’ buying power.
- In the 1970s, the United States had some of the highest rates of inflation in recent history, with interest rates increasing to nearly 20%.
- This decade of high inflation was fueled by central bank policy, the removal of the gold window, Keynesian economic policies, and market psychology.
What was the level of inflation in the 1970s?
In the United States, the 1970s were the decade of inflation. While it may come as a surprise to some that the average inflation rate for the decade was only 6.8%, this pace is roughly quadruple the rate of the previous two decades and double the long-run historical norm (see table 12.1).
In the 1970s, how long did stagflation last?
You may have heard a lot about stagflation in the United States in the 1970s, when energy costs rose due to an OPEC-led embargo, with oil prices tripling from 1973 to 1975.
Why was 2011’s inflation so high?
In September, the Consumer Price Index, the government’s main gauge of inflation at the retail level, increased by 3.9 percent over the previous year. Higher food and energy prices were once again the main culprits, with food prices up 4.7 percent year over year and energy prices up 19.3 percent.
Even core CPI, which excludes volatile food and energy costs, increased by 2%, putting it at the upper end of the range considered acceptable by the Federal Reserve.
However, there were indicators that the rate of increase was slowing. Prices increased by 0.3 percent month over month, down from 0.4 percent in August. In addition, the monthly core CPI rose by 0.1 percent, down from 0.2 percent the previous month and the smallest increase since March.
This year’s higher costs will result in a 3.6 percent increase in Social Security benefits in 2012, the first since 2009. Following the financial crisis, there was little to no inflation, therefore seniors did not get any cost-of-living adjustments in 2010 and 2011.
What is creating 2021 inflation?
As fractured supply chains combined with increased consumer demand for secondhand vehicles and construction materials, 2021 saw the fastest annual price rise since the early 1980s.
In 1974, why was inflation so high?
This is how the tale goes: The Vietnam War cost President Lyndon B. Johnson a lot of money. The economy was saturated with money as a result of wartime spending, and prices began to rise. The entire economy lost faith in the assumption that prices would remain stable as a result of LBJ’s extravagant spending and the Federal Reserve’s willingness to tolerate it. Once everyone expected inflation, it became a self-fulfilling prophecy: workers demanded higher salaries because they expected prices to rise; businesses raised their prices because they expected wages to rise; and so on, in an ever-escalating “wage-price spiral.”
The inflation rate was nearing double digits, or possibly higher, towards the end of the 1970s, depending on the measure.
The Federal Reserve’s new, bold strategy brought the experience to a close. Now, here’s a quick rundown of how the Federal Reserve influences the economy: The Federal Reserve, in general, is in charge of determining how much money is flowing in the economy at any particular time. Inflation can occur when there is too much money; too little money can result in low inflation, but it can also cause firms and families to have difficulty borrowing money, bringing the economy to a halt.
The Fed chose to grind the economy to a halt in 1979 in order to control inflation. When Jimmy Carter appointed Paul Volcker as Fed chair that year, he raised interest rates, effectively shutting off the Fed’s money supply and warning to markets that additional rate hikes would follow until the situation was resolved.
Inflation began to fall gradually, but two harsh recessions in the early 1980s pushed the jobless rate to its highest level since the Great Depression. The method worked because the Fed demonstrated its willingness to “shed blood, lots of blood, other people’s blood” to bring inflation under control, according to Reagan aide Michael Mussa.
Today, that story lingers over the economy. Inflation-watchers see the high-spending Biden administration and its extremely cooperative economic policy partner, Federal Reserve Chair Jerome Powell, as a replay of the 1970s inflation story.
Biden signed a $1.9 trillion stimulus bill less than two months after taking office, with the majority of the money going toward $1,400 payments to most Americans. Powell is accommodating this strategy by keeping interest rates around zero and buying Treasury bonds, effectively supporting the stimulus with printed money; moreover, during the debate over Biden’s bill, he urged Congress to pursue stimulus, dismissing fears that this would generate inflation.
Worries of a 1970s flashback appear to be justified, with inflation reaching 3.4 percent in May, the highest level in 30 years. But there’s reason to believe that the threat of a rerun is exaggerated. New economic study reveals that the picture of the Great Inflation of the 1970s told by orthodox economics may not be totally accurate.
Other policies and conditions that may have contributed to the tragedy of the 1970s are examined in this new account, which had traditionally been overlooked in historical narratives. This narrative focuses on specific difficulties that drove inflation in the 1970s that are no longer relevant now, such as an energy crisis and upheaval in global food markets.
To put it another way, this time could be different. Understanding this should assist policymakers steer policymakers away from pouring “other people’s blood” unnecessarily.
The standard story of the Great Inflation of the 1960s and ’70s
We can observe that prices began to climb more rapidly year over year during the mid-1960s, using the Fed’s favored measure of inflation.
They varied a little after a brief recession in 1970, but then soared to new heights in 1974-75 and again at the close of the decade. Inflation rose after Volcker’s inauguration in 1979, but quickly fell. It has never again exceeded 4% on an annual basis.
According to popular belief, the Great Inflation was the outcome of a series of policy decisions beginning with President Lyndon B. Johnson’s fiscal policies, particularly the Vietnam War.
While Johnson raised taxes to pay for some of his domestic initiatives, such as Medicare, he and Congress were hesitant to boost taxes to pay for the war. That meant the conflict or more especially, the money spent on the war was boosting the economy at a time when it was already booming, with no taxes to slow things down. The government was just injecting more money into a private economy that didn’t have much spare capacity, implying that the money would only be passed on to consumers in the form of higher prices.
The traditional narrative, on the other hand, focuses solely on Vietnam as the primary reason. The underlying cause has to do with a trade-off known as the “Phillips curve” by economists (named after economist A.W. Phillips).
The Phillips curve is a plot of the unemployment rate against the inflation rate in its most basic form, and it is usually downward sloping: the greater the inflation rate, the lower the unemployment rate. From the Federal Reserve Bank of St. Louis, here’s an example of a Phillips curve graph:
In essence, policymakers in the 1960s believed they could simply move left on the Phillips curve, to a point with higher inflation and lower unemployment, without much pain, as Brad DeLong argued in his excellent history of the Great Inflation.
They were, however, mistaken. According to the report, lowering unemployment too low threatens not only higher inflation (as the Phillips curve predicts), but also accelerating inflation, or inflation that continues to rise without halting.
This occurs as a result of expectations: once it is evident that the Federal Reserve is unconcerned about inflation and will do little to curb it, firms and consumers begin to anticipate and plan for it. Workers may demand more pay since they know that $1,000 now will be worth much more in a year or even a month. For the same reasons, businesses will hike prices.
These dynamics produce inflation in the form of increasing salaries and prices, which strengthens people’s expectations of future inflation, resulting in a poisonous loop.
According to economists Richard Clarida (now the Fed’s vice chair), Jordi Gal, and Mark Gertler, inflation was considered at risk of spiraling out of control under Fed policy at the time “because individuals (correctly) anticipate that the Federal Reserve will accommodate a rise in expected inflation.”
With Volcker’s appointment, the tale took a new direction. Volcker slashed interest rates drastically, ostensibly to show that the Fed was serious about suffocating inflation. It would do whatever it takes to enforce the law, including boosting interest rates to levels that caused two recessions in 1980 and 1981-82.
According to Clarida, Gal, and Gertler, Volcker and his successor Alan Greenspan’s policies eliminated the prospect of self-fulfilling inflationary cycles. “The Federal Reserve adjusts interest rates sufficiently to moderate any changes in projected inflation,” the Volcker policy stated.
The (assumed) trade-off between unemployment and inflation
Economists today dispute Johnson’s and his aides’ belief that you can just raise inflation without fear of triggering a spiral and receive lower unemployment as a result.
The NAIRU, a concept that has come to dominate Fed theory in recent decades, lies at the heart of their thinking. That’s the non-accelerating inflation rate of unemployment, or the level of unemployment below which experts predict inflation similar to that of the 1960s and 1970s.
What is the mechanism behind this? The NAIRU is currently estimated by the Congressional Budget Office to be 4.5 percent in the third quarter of 2021. The Fed should not let unemployment, which is currently at 5.9%, fall below 4.5 percent under NAIRU-driven policy, lest it tempt the inflation gods. And, like Volcker did, the way to achieve that is to raise interest rates.
One reason for concern among inflation watchers is that the Fed no longer has an NAIRU-driven policy references to NAIRU have been eliminated from the Fed’s statement of strategy under Powell.
Worriers like Blanchard and Summers are also concerned that Biden is doing what Johnson did with economic stimulus and other domestic spending instead of the Vietnam War; that he is juicing the economy so much that unemployment will quickly fall below the NAIRU, triggering an inflationary spiral that can only be stopped by a painful economic contraction down the road.
The mainstream story comes with two key caveats. One is that you may believe its basic assumption while still believing that the actual NAIRU is very, very low, lower than the CBO estimate of 4.5 percent and even lower than the 3% rate that supposedly caused difficulties in the 1970s. That is, the economy may continue to grow rapidly for a long time while lowering unemployment to historic lows without causing inflation difficulties.
Jn Steinsson, a UC Berkeley professor who, together with his co-author Emi Nakamura, has contributed to making macroeconomics considerably more empirically grounded, believes this is the case. He informed me that he is still convinced that inflation expectations and the credibility of the Federal Reserve are important. However, his study leads him to conclude that NAIRU could be extremely low, and that we could aspire for extremely low unemployment rates without fear of inflationary forces.
“The unemployment rate, if you just track it, it just keeps lowering,” Steinsson told me over the phone, “whether you look at the 1980s expansion, the 1990s expansion, or the 2010s expansion.” It just keeps falling and falling and falling, with no end in sight. Maybe it will at some time, but one point of view is that we’ve never gotten to the point of actual full employment.” Indeed, the US had unemployment at or below 4% for two years prior to Covid-19, with no inflationary issues.
Another caveat to the common scenario is that some economists believe the increase in aggregate demand that led to the Great Inflation in the 1960s and 1970s was partly due to an obscure rule known as Regulation Q, which capped interest rates on checking and savings accounts, rather than Vietnam.
For the first time in 1965, Q’s cap (then 4%) went below the Federal Reserve’s interest rate. This meant that everyone having money in a checking or savings account was earning less than the market rate – they were losing money.
This, according to economists Itamar Drechsler, Alexi Savov, and Philipp Schnabl, resulted in a significant outflow of deposits from the banking sector. This increased aggregate demand by encouraging consumers to spend rather than conserve their money while also contracting the economy since banks had less money to lend out to firms as a result of fewer deposits. With the introduction of Money Market Certificates and Small Saver Certificates, which offered market-rate interest with no caps in 1978 and 1979, Regulation Q was effectively repealed, and the Great Inflation began to fade shortly after.
There are reasons to doubt this story (for example, the Great Inflation happened in a bunch of other countries that didn’t have Regulation Q), but it matches the timing of the rise and fall in inflation eerily well, suggesting that a repeat of that exact situation is unlikely Joe Biden isn’t proposing bringing Regulation Q back.
What if inflation is not about the price of everything, but the prices of a few specific things?
However, there is another big flaw in the popular tale of inflation in the 1970s: it ignores certain extremely significant geopolitical events at the time. When these factors are considered, current fears of a return to 1970s-style inflation begin to fade.
The 1973 oil embargo, which saw Saudi Arabia and its Arab allies stop oil deliveries to the United States and some of its allies in retribution for supporting Israel in the Yom Kippur War, is a minor footnote in the inflation expectations saga. Some, like former Fed Chair Ben Bernanke in his previous academic work with Gertler and Mark Watson, contend that the embargo was largely irrelevant because of the Fed’s reaction, which was to hike interest rates considerably (though not as much as Volcker would later on).
However, that argument appears to be unrealistically dismissive of the consequences of a simple fact: petrol prices nearly doubled between October 1973 and January 1974.
While the oil shock was the most well-known of the period’s supply shocks, it was far from the only one. Prices for commodities of all kinds soared in the 1970s, from oil to minerals to agricultural products like grain. And, in many cases, these booms were obviously linked to supply-side difficulties, rather than price inflation induced by consumers with too much money. The price of grain, for example, soared in part as a result of a major drought in the Soviet Union in 1972, which drastically limited the country’s food production, prompted it to buy the United States’ entire wheat reserves, and pushed up global food prices.
Skanda Amarnath, executive director of the macroeconomic policy organization Employ America, explains that during the 1960s and 1970s, the baby boom in the United States and Europe, as well as the resulting higher population, increased demand for these commodities and goods, and supply struggled to keep up in the absence of more capacity expansion investment.
“A fast speed of investment in everything from houses to oil wells was the response to these demographic-induced shortages,” Amarnath told me. “It takes years of exploration and development in the oil industry to convert initial investment into increased production capability.” That investment would eventually pay off and aid in the alleviation of shortages, but while those shortages raged, the effect may be inflation.
The introduction and removal of President Richard Nixon’s wage and price regulations were another supply-side impact. Nixon terminated the dollar’s convertibility to gold in 1971, removing a crucial component of the system that had been stabilizing exchange rates between the United States and the rest of the world since World War II. Nixon established obligatory wage and price limitations from 1971 to 1974 in an attempt to reduce the aftershocks. Prices were momentarily restrained by the limits until they were lifted, contributing to the inflationary spiral that began in 1974.
Since at least 1979, economist Alan Blinder has argued for a supply-centered explanation, and he and colleague Jeremy Rudd characterized the “supply-side” position succinctly in a 2013 paper.
They point out that the Great Inflation was actually two: one between 1972 and 1974, which “can be attributed to three major supply shocksrising food prices, rising energy prices, and the end of the Nixon wage-price controls program,” and another between 1978 and 1980, which reflected food supply constraints, rising energy prices, and rising mortgage rates. Mortgage interest payments were included in the most widely used inflation measure until 1983, which meant that when the Fed responded to inflation by raising interest rates which in turn caused mortgage rates to rise this policy change increased measured inflation on its own.
The policy implications of a supply-side account for 1970s inflation are vastly different from the “Volcker shock” of high interest rates intended to shrink the economy. Instead of lowering demand and expenditure to meet the period’s lower supply, economists like then-American Economic Association president and future Nobel Laureate Lawrence Klein advocated in 1978 that the government should actively try to raise the supply of certain rare products. This could have taken the form of efforts to increase crop yields or support domestic oil production in the United States.
We’ll never know if it succeeded, but it’s a compelling and in my opinion persuasive alternative to the story we’ve been taught for decades.
What this revised story of the Great Inflation means for policy in 2021
This alternate tale suggests that Federal Reserve Chair Jerome Powell should not contemplate slowing the economy as a blunt tool to keep prices down in 2021. Instead, the federal government should intervene in specific regions to prevent certain sorts of fast growing costs from becoming even more so.
As my colleagues Emily Stewart and Rani Molla have pointed out, the most significant price rises affecting consumers are in the food and beverage sector “In recent months, new and used cars, as well as air travel, have contributed to “core” non-gas or food inflation. According to the Biden Council of Economic Advisers, vehicle prices alone accounted for at least 60% of inflation in June, with a large portion of the rest coming from services like air travel rising in price as everyone rushes back to travel following the pandemic.
A semiconductor shortage accounts for a large portion of the growth in automobile prices, meaning that improving semiconductor supply, particularly increasing production in the United States, might be a better method to combat inflation than raising interest rates. The kind of intervention anticipated by this approach is Biden’s recent efforts to get Taiwan to increase manufacturing for US automakers.
Powell recently testified to Congress that the Fed is thinking along these lines “Supply restrictions have slowed activity in some areas, most notably in the automotive industry, where a global scarcity of semiconductors has drastically reduced production this year.” The same has been said by Lael Brainard, a powerful member of the Federal Reserve’s Board of Governors.
“If you believe this supply-side story is credible, that changes the way you want to think about things,” Steinsson explained. “Someone is going to build a new semiconductor factory at some point, so there’s no reason to use the blunt tool of hiking loan rates across the board.”
Yes, inflation is growing, there is a lot of uncertainty, and the 1970s are looming large. Given how much economic misery was inflicted on millions of people in the struggle against inflation decades ago, it’s reassuring that today’s leaders are more inclined to consider the path that their forefathers did not.
Why was inflation so high in the United Kingdom in the 1970s?
- The mortgage market was deregulated by the Bank of England, which meant that High Street Banks may now lend mortgages (not just local building societies). This contributed to an increase in home values and consumer wealth.
- 1972 was the year of the Barber Boom. With huge tax cuts against a backdrop of rapid economic growth, chancellor Anthony Barber made a beeline for growth in the 1972 budget.
- Credit expansion. The first widespread use of credit cards occurred in the 1970s (Access). This aided in the formation of a consumption bubble.
When did inflation start to rise?
Between 1914 and 2022, the United States’ inflation rate averaged 3.25 percent, with a high of 23.70 percent in June 1920 and a low of -15.80 percent in June 1921.
Which year had the highest rate of inflation?
The highest year-over-year inflation rate recorded since the formation of the United States in 1776 was 29.78 percent in 1778. In the years since the CPI was introduced, the greatest inflation rate recorded was 19.66 percent in 1917.