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Let’s not fight the last (inflation) war

We need to diagnose today’s inflation problem correctly and not fit everything into the paradigm of the 1970s.

Federal Reserve Chair Paul Volcker
In October 1979, Federal Reserve Chair Paul Volcker, shown in a photo from 1996, announced a change in policy along the lines advocated by Minnesota economists. The Fed would no longer control interest rates but would focus on the growth of the money supply instead.

The headline, “I Remember 1970s Inflation. Politicians Should, Too,” caught my eye recently. More and more people today seem obsessed with the economic upheaval of the 1970s and are using the fear of repeating that episode as a guide for fighting today’s inflation.

It turns out that policymakers in the 1970s were doing something similar. They still remembered the massive unemployment of the Great Depression. Their fear of repeating that economic collapse led them to enact policies that they thought would prevent another depression but that led to higher inflation.

Fighting the last war ended badly in the 1970s and it will end badly today. We need to understand what happened in the 1970s and avoid applying the wrong historical analogy as we deal with higher inflation rates today.

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The 1970s

Inflation started increasing in the late 1960s, rising from 1-2% to 3%, which didn’t set off any alarm bells. As the inflation rate continued to creep up, policymakers of the time decided to tolerate it as the price for avoiding another Great Depression and the job losses they so feared.

This economic analysis was based on the concept of the Phillips Curve, which posited that there was a stable relationship between inflation and unemployment. Specifically, lower rates of unemployment drove up inflation rates, so the price of reducing unemployment was living with higher inflation.

However, as the 1960s turned into the 1970s inflation continued to rise, reaching a worrisome 5-6% by 1971. Richard Nixon enacted wage-price controls in August 1971, followed by less formal guidelines for wages and prices. Gerald Ford declared inflation “public enemy number one” and called for a campaign to Whip Inflation Now (WIN).

These steps failed to slow inflation, which reached an alarming 12% in 1975 and a disruptive 14% in 1980. Worse still, unemployment also rose! This distressing combination of rising inflation and rising job loss earned the moniker “stagflation” (stagnating job growth and rising inflation).

Clearly, the Phillips Curve was wrong. Accepting higher inflation did not protect jobs.  So, a new analysis was needed.

In stepped economists associated with the Federal Reserve Bank of Minneapolis and the University of Minnesota, who argued that there was no trade-off between inflation and unemployment. You could fight inflation without fearing job loss by enacting strong, credible monetary policy. In particular, by announcing a change in policy from tolerating rising inflation to reducing inflation and showing that you meant it by slowing the growth of the money supply, inflation would fall but unemployment would not rise.

In October 1979, Paul Volcker (who had recently been appointed chair of the Federal Reserve) announced a change in policy along the lines advocated by the Minnesota economists. The Fed would no longer control interest rates but would focus on the growth of the money supply instead. This meant that interest rates could rise as high as the financial markets would take them, which they did, hitting 19 percent (on the federal funds rate) in January 1981.

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Volcker had been advocating this type of policy as an assistant secretary of the Treasury in the early 1970s and as president of the Federal Reserve Bank of New York starting in 1975. He did not, however, believe that the Minnesota analysis was correct. Rather, Volcker argued that the only way to stop inflation was to throw the economy into a sharp, deep recession. It was the price America needed to pay.

In fact, these policies did put the economy into a deep recession that lasted until 1983.  The Minnesota analysis of costless (or at least, low cost) inflation reduction was wrong.

But Volcker’s policies did stop the inflation scourge. Inflation fell from 14 percent in 1980 to 3 percent in 1983 and has stayed relatively low and stable ever since.

Lessons of the 1970s

Economists and those who make economic policy drew two important lessons from the 1970s experience:

  1. Don’t let inflation accelerate. It’s hard to stop once it gets going.
  2. If inflation starts to accelerate, raise interest rates, induce a recession, and kill off the increase in inflation.

As a result, a new synthesis emerged in macroeconomic theory as well, and that has been at the heart of much economic research since the 1980s. This framework has three pillars:

  1. There is a short-run trade-off between inflation and unemployment (and this justifies the Volcker approach).
  2. But, expectations about policy matter and thus we need to keep inflation under control so that people don’t expect higher inflation.
  3. Thus, in the long run, there is no trade-off between unemployment and inflation.

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What do we do today?

There is no doubt that inflation has risen over the past year. Observers such as  Lawrence Summers see this as a sign that we need to go back to the Volcker play book, that is, the Fed should raise interest rates and, if necessary, we must accept slower growth or even a sharp and deep recession to prevent inflation from getting out of hand.

They are fighting the last war. Just as policymakers in the 1970s were convinced that they had to prevent another Great Depression, Summers and other economists think that they must prevent another Great Inflation.

What if they are wrong? As I explained in a previous column, inflation today is different than the inflation of the 1970s. It’s not clear that raising interest rates and causing a recession would do much to reduce inflation. It might help, but only by throwing people out of work, reducing their incomes, and forcing them to spend less. This would take the pressure off supply chains and probably reduce the inflation rate.

However, we don’t want to treat a heart attack (runaway inflation) when all we have is a case of indigestion (mild inflation that will slow as the economy returns to post-pandemic stability). We need to diagnose the problem correctly and not fit everything into the paradigm of the 1970s.

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Inflation today is affecting only certain sectors of the economy and is primarily the result of pandemic disruptions. All of this will calm down in the coming months, and no drastic measures are necessary at this time. In fact, big increases in interest rates and contractionary policies such as reducing federal spending would make us worse off economically.

Let’s use the correct historical analogy. Our inflation problems are akin to those we faced during the postwar reconversions of the 1940s and 1950s. Then, the Federal Reserve kept interest rates low and stable and inflation rates came down as the U.S. economy went back to a peacetime footing. This is the case from which we should draw lessons, not 1970s stagflation.

The Federal Reserve is ready to act against inflation if there is any sign that it is permanently accelerating. They learned the lessons of the 1970s and will do whatever it takes to keep inflation under control. In the meantime, they will resist being drawn into the wrong war at the wrong place at the wrong time.