The Last Great Inflation and What It Says About the Present One

With inflation now firmly in the headlines (and in our lives), a look back at the last experience with this menace may offer needed perspective.  Of course, history never repeats exactly, and there is no claim here that it will.  Nonetheless, a look back will provide ammunition to counter much of the nonsense appearing in the media these days and, I trust, identify what is important.     

The historic Arab oil embargo of 1973 dominates most references to the last great inflation.  No doubt oil played a role, but there were problems long before the embargo.  Inflation began to build in the second half of the 1960s.  By 1966, after years of barely any inflation, consumer prices were rising at a 3.5 percent annual rate and then, feeding on themselves, spiraled by 1969 to 6.0 percent.  (As of this writing, the annual inflation rate is running at 7 percent.)  

This initial price pressure had two clear roots.  One was the strain President Lyndon Johnson placed on the federal budget and on the economy by simultaneously pursuing the war in Vietnam and a domestic War on Poverty; second was the willingness of the Federal Reserve (Fed) to accommodate the government’s credit needs by creating an enormous flow of new money.  The broad measure of the nation’s money supply rose at what –– for those years in the Sixties –– was an average and rapid 8.0 percent a year.

When President Nixon took office in 1969, he continued to spend freely, even though the war in Vietnam was winding down.   Nixon added a special inflationary factor to the mix: On August 15, 1971, he ended the dollar’s convertibility to gold, a move that destroyed the fixed international exchange rate system that had prevailed for decades.  The dollar subsequently fell on global exchange markets, which added directly to American living costs by raising the prices of imports.  More fundamentally, the break with gold removed any restraint on the Fed’s ability to create new money.  Between 1971 and 1973, average growth in the country’s money supply soared at rates approaching 12 percent a year.  Along with federal spending, abandoning the link to gold made buying easier, which added to the inflationary trend, quickly hiking the rate of increase in prices back toward the 1969 highs (following a brief slowdown during a mild recession in 1971).

Oil entered the picture in 1973.  By then the members of the Organization of Petroleum Exporting Countries (OPEC) had begun to chafe over how the American inflation was eroding the real value of their product.  While other dollar prices were rising, oil, set by American interests, had held at a relatively steady $25.00 a barrel.  That year, OPEC took control of pricing by imposing an embargo on oil sales and then it quadrupled oil prices.  

The Fed responded by pouring still more money into the economy.  The broad money supply jumped 14 percent in 1974.  The Fed had intended this flow to ease the economic strains of high oil prices, but the added money mostly extended, and enlarged, the immediate inflationary impact of the one-time jump in oil prices.  By early 1975, inflation was running at over 11 percent a year.   

And by 1979, consumer price inflation neared 14 percent a year, and its economic harm had become widespread.  By mangling notions of value, inflation had destroyed wealth and distorted incentives, retarding the capital spending that would otherwise have fostered economic growth.  Bond and stock prices had crashed, with the S&P 500 stock price index falling some 20 percent from 1976 to the end of the decade, and 10-year treasury bond prices falling some 30 percent.  Because the Fed was accommodating inflation, the widespread expectation was that it would continue to do so: workers made wage demands on the expectation of rapid increases in their cost of living, and managements granted them on the expectation they could easily raise prices to more than offset their increase labor cost.  This so-called wage-price spiral gave inflation a life of its own, even as workers fell further behind in the real value of their earnings.  The suffering was widespread.   

The end to this inflation came when a new Fed chairman, Paul Volcker, refused to go along with the inflation (as the Fed had previously done): He cut the rate of money growth.  Without a ready source of Fed-provided liquidity, interest rates spiked skyward.  Yields on 10-year treasury bonds briefly hit 16 percent, and short-term interest rates touched 21 percent.  These responses were painful, but by finally ending the inflation-fueling flood of liquidity, allowing the Volcker Fed to break the inflationary spiral.  By 1983, after years in which mistaken policy had fueled inflation, the rate for consumer prices had fallen below 3 percent a year.

Though much about today’s picture looks different, much also resembles that historic bout of inflation. Washington is today spending even more aggressively than it did 40-50 years ago.  Similarly, the Fed has pursued an expansive monetary policy.  Though policy-makers recently promised a more restrictive monetary posture, their announced plans suggest only the most gradual of moves.  The U.S. economy may get lucky, but the picture looks disturbingly like it did the last time.                      

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