With the exception of the world wars, the Great Depression, and a few brief periods, inflation in the United States during the twentieth century kept around 5% for the most part – except during the 1970s.
How serious was the Great Depression’s inflation?
The Great Depression was a period of economic hardship. 1 Between the years of 1930 and 1933, prices fell by an average of about 7% per year. 4 During the Great Depression, there was a significant decline in output in addition to a drop in prices.
Was there a lot of inflation during the Great Recession?
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.
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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.
During a depression, does inflation rise?
Inflation and deflation are linked to recessions because corporations have surplus goods due to decreasing economic activity, which means fewer demand for goods and services. They’ll decrease prices to compensate for the surplus supply and encourage demand.
What caused the Great Depression’s inflation?
Austrian economists claim that the Great Depression was a foregone conclusion as a result of the Federal Reserve’s monetary policies in the 1920s. The central bank’s strategy of “loose credit” resulted in an unsustainable credit-fueled boom. During this time, money supply inflation caused an unsustainable boom in asset values (stocks and bonds) as well as capital goods. It was too late to avoid a major economic recession when the Federal Reserve finally tightened monetary policy in 1928. Government involvement after the 1929 catastrophe, according to Austrians, slowed the market’s adjustment and made the road to full recovery more arduous.
Acceptance or denial of the Monetarist explanation is compatible with acceptance or denial of the Austrian account of what caused the Great Depression. Murray Rothbard, an Austrian economist who wrote America’s Great Depression (1963), dismissed the Monetarist theory. He disputed Milton Friedman’s contention that the central bank did not do enough to expand the money supply, saying instead that the Federal Reserve did pursue an inflationary strategy when it purchased $1.1 billion in government assets in 1932, bringing its total holdings to $1.8 billion. “Total bank reserves barely climbed by $212 million, but the total money supply declined by $3 billion,” Rothbard claims, despite the central bank’s measures. He claims that the reason for this is that the American public lost faith in the banking system and began hoarding more currency, a factor outside the Central Bank’s control. Because of the risk of a bank run, local bankers were more cautious in lending out their reserves, which, according to Rothbard, was the reason of the Federal Reserve’s incapacity to inflate.
In the 1930s, Friedrich Hayek chastised the Federal Reserve and the Bank of England for not taking a more contractionary position. Hayek admitted in 1975 that he made a mistake in the 1930s by not opposing the Central Bank’s deflationary policy, and explained why: “At the time, I believed that a process of deflation of some short duration might break the rigidity of wages, which I thought was incompatible with a functioning economy.” He stated in 1978 that he agreed with the Monetarists’ point of view, adding, “I agree with Milton Friedman that once the Crash occurred, the Federal Reserve System pursued a stupid deflationary policy,” and that he opposed deflation as much as he opposed inflation. In a similar vein, economist Lawrence White claims that Hayek’s business cycle theory is incompatible with a monetary policy that allows for a large reduction of the money supply.
What happens if inflation gets out of hand?
If inflation continues to rise over an extended period of time, economists refer to this as hyperinflation. Expectations that prices will continue to rise fuel inflation, which lowers the real worth of each dollar in your wallet.
Spiraling prices can lead to a currency’s value collapsing in the most extreme instances imagine Zimbabwe in the late 2000s. People will want to spend any money they have as soon as possible, fearing that prices may rise, even if only temporarily.
Although the United States is far from this situation, central banks such as the Federal Reserve want to prevent it at all costs, so they normally intervene to attempt to curb inflation before it spirals out of control.
The issue is that the primary means of doing so is by rising interest rates, which slows the economy. If the Fed is compelled to raise interest rates too quickly, it might trigger a recession and increase unemployment, as happened in the United States in the early 1980s, when inflation was at its peak. Then-Fed head Paul Volcker was successful in bringing inflation down from a high of over 14% in 1980, but at the expense of double-digit unemployment rates.
Americans aren’t experiencing inflation anywhere near that level yet, but Jerome Powell, the Fed’s current chairman, is almost likely thinking about how to keep the country from getting there.
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Prices for used cars and trucks are up 31% year over year. David Zalubowski/AP Photo
In 1979, how much did inflation cost?
Between 1979 and 2018, the average annual inflation rate is 3.23 percent compounded. As previously stated, this annual inflation rate adds up to a total price difference of 246.05 percent over 39 years.
To put this inflation into context, if we had invested $100 in the S&P 500 index in 1979, our investment would now be worth nearly $1,500.
Was there inflation or deflation during the Great Recession?
From December 2007 to June 2009, the US economy was in a recession, according to the National Bureau of Economic Research (NBER). It was the post-World War II era’s longest and deepest recession. Two main phases of the recession can be identified. The recession was not severe during the first phase, which lasted for the first half of 2008, as judged by the loss in GDP and the rise in unemployment. From the third quarter of 2008 to the first quarter of 2009, it became more severe. In the second quarter of 2009, the economy continued to shrink somewhat before rebounding in the third quarter. The most recent recession had the greatest drop in output, consumption, and investment, as well as the highest increase in unemployment, of any postwar recession.
Previously, the postwar recessions that began in 1973 and 1981 were the longest and deepest. Both of those recessions occurred during periods of high inflation, making the Federal Reserve (Fed) unwilling to decrease interest rates significantly to encourage economic activity. During the recent recession, the Fed showed no such hesitancy, lowering short-term rates to near-zero levels. Inflation rose above the Fed’s “comfort zone” in 2007 and 2008, but not nearly as much as it did during the 1970s and 1980s recessions. At the end of 2008, the economy temporarily suffered deflation (lower prices), and inflation has stayed low since then. Although some analysts are concerned that the Fed’s policies would produce inflationary concerns once the economy recovers to full employment, deflation may pose a greater threat to the economy in the short term.
Both the 1973 and 1981 recessions, as well as the current one, saw big jumps in oil prices towards the start of the downturn. Throughout the postwar period, oil market disruptions and recessions have gone hand in hand.
The previous two recessions (which began in 1991 and 2001, respectively) were unusually mild and brief, but they were followed by long jobless recoveries, when growth remained slow and unemployment continued to rise. Although the recent crisis did not result in a longer-than-normal jobless recovery, employment growth has been slow in 2010.
It is not rare for residential investment (home construction) to fall during a recession, and it is also not uncommon for residential investment to fall more abruptly than corporate investment and to start falling before the recession. However, as evidenced by the atypical drop in national house values, the recent reduction in residential investment was extremely severe.
The extreme disruption of financial markets was a standout feature of the current recession. In August 2007, financial situations began to deteriorate, but they worsened in September 2008. While financial downturns are prevalent in conjunction with economic downturns, financial markets have remained stable in previous recessions. As a result of this distinction, some pundits have compared the recent recession to the Great Depression. While the beginnings of both crises are similar, the impact on the broader economy are very different. GDP decreased by over 27%, prices fell by more than 25%, and unemployment surged from 3.2 percent to 25.2 percent during the Great Depression’s first recession, which lasted from 1929 to 1933. The latest recession’s fluctuations in GDP, prices, and unemployment were far closer to those seen in past postwar recessions than the Great Depression. Most economists attribute the Great Depression’s severity to policy mistakes, particularly the choice to allow the money supply to decline and tens of thousands of banks to fail. Policymakers, on the other hand, have aggressively interfered to revive the economy and offer direct aid to the financial industry throughout the recent recession.
Is inflation caused by a recession?
The Fed’s ultra-loose monetary policy approach is manifestly ineffective, with inflation considerably exceeding its target and unemployment near multi-decade lows. To its credit, the Fed has taken steps to rectify its error, while also indicating that there will be much more this year. There have been numerous cases of Fed tightening causing a recession in the past, prompting some analysts to fear a repeat. However, there have been previous instances of the Fed tightening that did not result in inflation. In 2022 and 2023, there’s a strong possibility we’ll avoid a recession.
The fundamental reason the Fed is unlikely to trigger a recession is that inflation is expected to fall sharply this year, regardless of Fed policy. The coming reduction in inflation is due to a number of causes. To begin with, Congress is not considering any more aid packages. Because any subsequent infrastructure and social packages will be substantially smaller than the recent relief packages, the fiscal deficit is rapidly shrinking. Second, returning consumer demand to a more typical balance of commodities and services will lower goods inflation far more than it will raise services inflation. Third, quick investment in semiconductor manufacturing, as well as other initiatives to alleviate bottlenecks, will lower prices in affected products, such as automobiles. Fourth, if the Omicron wave causes a return to normalcy, employees will be more eager and able to return to full-time employment, hence enhancing the economy’s productive potential. The strong demand for homes, which is expected to push up rental costs throughout the year, is a factor going in the opposite direction.
Perhaps the most telling symptoms of impending deflation are consumer and professional forecaster surveys of inflation expectations, as well as inflation compensation in bond yields. All of these indicators show increased inflation in 2022, followed by a dramatic decline to pre-pandemic levels in 2023 and beyond. In contrast to the 1970s, when the lack of a sound Fed policy framework allowed inflation expectations to float upward with each increase in prices, the consistent inflation rates of the last 30 years have anchored long-term inflation expectations.
Consumer spending will be supported by the substantial accumulation of household savings over the last two years, making a recession in 2022 extremely unlikely. As a result, the Fed should move quickly to at least a neutral policy position, which would need short-term interest rates around or slightly above 2% and a rapid runoff of the long-term assets it has purchased to stimulate economic activity over the previous two years. The Fed does not have to go all the way in one meeting; the important thing is to communicate that it intends to do so over the next year as long as inflation continues above 2% and unemployment remains low. My recommendation is to raise the federal funds rate target by 0.25 percentage point at each of the next eight meetings, as well as to announce soon that maturing bonds will be allowed to run off the Fed’s balance sheet beginning in April, with runoffs gradually increasing to a cap of $100 billion per month by the Fall. That would be twice as rapid as the pace of runoffs following the Fed’s last round of asset purchases, hastening a return to more neutral bond market conditions.
Tightening policy to near neutral in the coming year is unlikely to produce a recession in 2023 on its own. Furthermore, as new inflation and employment data are released, the Fed will have plenty of opportunities to fine-tune its policy approach. It’s possible that a new and unanticipated shock will affect the economy, either positively or negatively. The Fed will have to be agile and data-driven, ready to halt tightening if the economy slows or tighten much more if inflation does not fall sharply by 2022.