As the graph below shows, the 1970s stand out as a period in which the U.S. had poor price level stability despite having a central bank, an advanced industrial economy, and educated policymakers. Therefore, understanding why this period (dubbed the Great Inflation ) of price level instability (relative to other periods of U.S. history) occurred is a matter of economic and public policy importance insofar as price instability can severely harm economic growth.
The Who, What, When, and How of the Great Inflation:
At first glance, the simplest explanation for the Great Inflation is rooted in the postwar economic expansion that the U.S. experienced as well as the economic policy pursued during these years. Taken together, there may be reason to think that inflationary pressures stemmed from demand-pull factors. Especially supportive of this view is that macroeconomic policy was guided by Keynesian theory (think 1965 TIME cover), including goals of full employment as reflected in the Employment Act of 1946, as well aggressive fiscal stimulus over the 1960s and 1970s every time the economy showed signs of a slowdown. Consequently, these expansionary policies were pursued by both conservatives (Nixon’s fiscal expansion ) and progressives (Kennedy Tax Cut). These repeated fiscal stimuluses, especially in an era where they were relatively new, could have resulted in inflationary pressures. Therefore, at least in part, the inflation of the 1970s could be characterized as a period of accelerating demand-pull inflation from excessive stimulus by macro authorities.
There are also reasons to consider a monetary explanation of the Great Inflation. Monetary policy of the time was partially guided by an erroneous belief in a stable trade-off between inflation and unemployment due to research by A.W. Phillips in the late 1950s. Consequently, Christina Romer has written an excellent paper on the role of economic ideas in causing the Great Inflation, some of which are shown in the table below. Of course, there are other potential reasons the Federal Reserve was a poor monetary authority in the 1970s. Allan Meltzer has suggested that inappropriate Federal Reserve policy was due to institutional and political factors which constrained policy options during the period and politicized the Fed. Consequently, it may have been that the monetary authorities were excessively dovish on inflation because they were unwilling to conduct policies that would lead to a strong economic contraction, especially when inflation expectations began to tick upwards.
Ultimately, no matter the cause, the Federal Reserve ran excessively expansionary monetary policy, if one believes the Taylor Rule is an accurate benchmark, during most of the 1970s as the graph below shows.
In this expansionary fiscal and monetary environment, the oil and food supply shocks of the 1970s were enough to fully ignite inflationary pressures. Work by the Federal Reserve as well as other recent research indicate that they were significant factors in explaining the Great Inflation phenomenon. In the chart below it is not difficult to see the relationship between the CPI energy and CPI food indexes and the uptick in the overall CPI.
Consequently, I ran a simple correlation matrix between the three indexes and found the following favorable results.
Consequently, the idea that these strong commodity price shocks exacerbated already inflationary domestic conditions is consistent with what Janet Yellen has noted in that:
“[M]onetary policy bears responsibility for the broad contour of what happened to actual and expected inflation during this period because the Federal Reserve was insufficiently focused on returning inflation to a predictable, low level following the shocks to food and energy prices and other disturbances.”
Certainly, these “other disturbances” should include the collapse of the Bretton Woods System and the U.S. shift away from the gold standard. First, the collapse led to a substantial decline in the value of the dollar which, when allowed to float, depreciated to $455 per ounce of gold, from its fixed value of $35 per ounce, by the end of the 1970s. This only made oil and food imports even more expensive, contributing to inflationary pressures from these sources. In terms of monetary policy, work done by Barry Eichengreen indicates that the end of the gold standard made possible an unprecedented discretionary monetary policy regime free from constraints which when combined with a push for full employment resulted in price level increases.
The Role of Microeconomic Factors:
Although I have discussed the macroeconomic features of the Great Inflation, there are several microeconomic issues worth briefly mentioning. Particularly, wage-setting behavior of the 1970s were a cause of inflation by creating additional purchasing power to fuel the rising price level. Research by Wachter indicates that there was a high level of rigidity in terms of wage contracts which were not responsive to anti-inflationary policies. Consequently, Social Security became indexed to inflation in the 1970s creating more purchasing power to ignite inflationary pressures. Related to the above two points, inflationary expectations took hold in the 1970s which made it difficult and unpleasant for the macro authorities to slow the price level increase. This notion is combined with macroeconomic thinking and captured in the expectations trap hypothesis. The above microeconomic points are well covered by Heilbroner in The Economic Transformation of America (p.317).
My Empirical Results:
To gain a greater understanding of the Great Inflation, I conducted a simple OLS regression, utilizing variables proxying for those factors analyzed above. These include CPI less food and energy to proxy general inflation, CPI Energy , CPI Food, the Effective Federal Funds Rate, the effective exchange rate index, the federal budget and real GDP data. My results, using percent change (expect for the exchange rate), quarterly data from 1965-1995 are shown below and are generally favorable to what is asserted above.
Can it Happen Again?
In short, it is unlikely that the U.S. will experience an inflationary 1970s redux due to (1) a credible monetary policy regime, (2) increased robustness in terms of price shocks and (3) structural factors that prevent high levels of inflation. In terms of monetary policy, the key development is that inflation expectations have become much better anchored since the 1970s. In a 2007 presentation Ben Bernanke highlighted a gradual flattening of the Phillips Curve and noted that this was largely the result of the more credible commitment to price stability that the Federal Reserve has maintained since the 1980s. In this case,
“[T]he incentive of the central bank to stimulate employment in the short run tends to produce an excessively high rate of inflation in the absence of a suitable commitment mechanism. Not until the development of new commitment devices in the form of a lexicographic intellectual commitment to price stability…at the beginning of the 1980s was the prevailing inflation reduced.”
Consequently, monetary policy advances have made the economy more resilient to recent inflationary shocks, a notion which has also been voiced by Janet Yellen. Further evidence comes from research by Barsky and Kilian who suggest that price shocks are unlikely to recreate 1970s type conditions as long as the Federal Reserve does not run excessively expansionary monetary policy. Of course, there are other factors at large in terms of price shocks. Particularly, research by Oliver Blanchard is illuminating in this vein, as it highlights that the contemporary U.S. economy is most likely more resilient to inflation from oil price shocks, due to the decline in U.S. dependence on oil. Evidence decreased inflation sensitivity to oil price shocks is certainly supported by the graph given below which emphasizes that, despite strong price shocks in the early 2000s inflation remained controlled.
Consequently, Alan Greenspan has asserted that much of the Federal Reserve’s success in maintaining price stability has been a result of structural shifts in the U.S. economy, such that:
“The principal features of this environment included (i) increased political support for stable prices… (ii) globalization, which unleashed powerful new forces of competition, and (iii) an acceleration of productivity, which at least for a time held down cost pressures.”
While we have seen a slowdown in productivity gains, the increasingly globalized state of the world still bodes well for the price level by diminishing inflationary pressures through increased competitive pressures which keeps product prices down and controls unit labor costs. Consequently, there has been concern over Trump’s plans for tax-cuts in terms of inflation. However, these are probably overblown considering the Federal Reserve’s recent rate hike plans and their willingness to lean against inflationary pressures caused by the President’s agenda by tightening liquidity.
Finally, the recent resilience of the economy in terms of resisting inflation has been reassuring. As I discussed in a previous blog, despite a large expansion in the money stock and recovering U.S. economy, inflationary pressures have remained mild in recent years despite fears. Well anchored inflation expectations, as I have stressed before, have certainly played a role in this price level stability. Consequently, while there has been a buildup of excess reserves which could be somewhat inflationary, experts have not been sufficiently alarmed and trust that the Federal Reserve can appropriately handle the threat.
Ultimately, the factors which caused the Great Inflation in the 1970s are simply not in play anymore. Similarly, new threats to price level stability are not immediate and likely to be tamed by the Federal Reserve indicating the U.S. is no danger of seeing another inflationary spiral.