People are talking about inflation as if it’s the 1970s. I keep checking to see if wide neckties or leisure suits are back in fashion, but neither inflation nor orange polyester jumpsuits are menacing our nation right now.
We’re not going back to the future. Inflation is higher than it has been in many years as prices for gasoline, used cars and other items rise at their fastest rates since the early 1990s. However, the causes of higher inflation today are different than 40 to 50 years ago, and we risk choking off a healthy economy by using the 1970s as a guide to economic policy.
What is inflation?
Inflation is an increase in the general level of prices across wide sectors of the economy. It is not a rise in the price of a particular good or service such as bread or dry cleaning. Knowing that the price of bread rose, for instance, doesn’t tell us much. Did it rise faster than the price of milk? More slowly? We need a standard against which we can measure price changes of individual items.
That’s where a price index, such as the Consumer Price Index (CPI), comes in handy for two reasons. First, the CPI measures the general (average) level of prices for goods and services that a typical household purchases each month and thus can be used to measure inflation. Second, the CPI gives a benchmark against which we can compare changes in the price of individual items (such as a loaf of bread) with prices more generally.
The Bureau of Labor Statistics (BLS) compiles the CPI monthly using information on 211 goods and services collected in 38 geographic areas. This allows the BLS to calculate CPIs for a variety of time periods, combinations of goods and services, and different community sizes.
Back to the ’70s?
Inflation in the 1970s was higher than today, accelerated over the decade and had a traumatic effect on economic policy. Starting from about 2 percent in the late 1960s, inflation rose to 12 percent in 1974 and 14.5 percent in 1980.
The underlying causes were, in retrospect, clear. First, we were hit with two oil shocks. The price per barrel of oil quadrupled during the 1973 oil embargo and then doubled again in 1979 as a result of the Iranian Revolution. Second, the Federal Reserve did not have a mandate to raise interest rates and slow down the economy to stop inflation from rising until President Carter appointed Paul Volcker as Federal Reserve chair in 1979.
Neither of these problems exist today. We have not experienced any price shocks of the magnitude of the oil price increases of the 1970s nor do any seem to be on the horizon. The Federal Reserve is committed to keeping the long-run inflation rate at 2 percent and Jerome Powell (or his successor as chair) and his colleagues will do whatever it takes to rein in inflation should it appear to be accelerating. Right now, there’s no sign of this happening.
In the U.S. today we see great variation in inflation rates and price increases (and decreases) across places and commodities, and, unlike the 1970s, there is not a broad-based pattern of all prices rising rapidly in all areas of the country.
The inflation rate for the US, as measured by the CPI between October 2020 and October 2021, was 6.2 percent. When we zero in on the Midwest (as defined by the Census Bureau), prices rose by 6.6 percent, with prices rising 5.8 percent in cities of 2.5 million or more (e.g. the Minneapolis-St. Paul area) and 7.1 percent in smaller areas.
These patterns hold for other areas as well: inflation was higher in smaller communities than in larger ones and lower the closer you live to one of the coasts. This suggests that increasing transportation costs, driven primarily by the rapid rise in gasoline prices and other petroleum products (caused primarily by the freaky freeze in the south in February 2021), are driving inflation rates as opposed to excessive demand on the part of consumers and businesses.
Product price variation:
Price changes varied considerably across different types of goods and services as well. For example, food prices rose 5.4 percent, with the price of white bread rising just 1.3 percent while beef increased a whopping 20 percent. Unleaded regular gasoline rose 51 percent, but electricity fell by 0.1 percent. “Recorded music and music subscriptions” decreased in price by 1.6 percent and smartphones fell 21 percent.
This is important because every family will feel inflation differently. A household that consumes a lot of beef, uses a lot of gasoline, and buys a lot of hard liquor (up 4 percent) will experience a higher inflation rate than one that buys chicken, drives a hybrid car, and drinks wine (up 0.4 percent).
Broad based inflation?
These data suggest that inflation is not being driven by broad factors but by causes that are hitting individual markets. Put another way, inflation is not higher because everything is getting more expensive but rather because prices in particular sectors of the economy are rising rapidly while other sectors are showing steady or falling prices. This shows up as an increase in the general CPI but it’s being driven by problems in individual market segments such as the supply-chain issues that wholesalers and retailers are dealing with today.
In brief, some sectors of the economy are seeing rising prices, which is driving up the CPI, but the rest of the economy is experiencing relatively stable prices with increases in the range of 2 to 4 percent per year. System-wide inflation is not occurring.
Reconversion: a better lesson from history
A better historical analogy than the 1970s for today’s inflation problem is the reconversion of the U.S. economy from wartime to peacetime production after World War II and the Korean War. For instance, civilian automobile production ended in early 1942 and didn’t resume until late 1945. It took time to reconvert factories from making aircraft engines to automobile engines.
Similarly, the pandemic caused entire sectors of the U.S. economy to shut down for weeks or months, then restart under pandemic conditions of social distancing, remote work and other changes in production practices. All this change takes time, and it will show up in competitive markets as higher prices. Parts and labor shortages cause prices and wages to rise, and that’s exactly how markets are supposed to work. The higher prices provide signals to businesses and households about what goods and services to produce, which industries are attractive to work in, and more generally how resources should be deployed throughout the economy. Prices will settle down as each market is able to resume its regular patterns.
There is a strong temptation, especially among politicians, to demand that President Biden, Congress, or someone do something to stop this rise in inflation. That’s the wrong way to think about our situation. Instead, we need to let markets work out the bugs of supply-chain issues, higher-than-usual fuel prices and other idiosyncrasies of today’s pandemic and post-pandemic economy.
And have no fear, we’re unlikely to see rainbow socks with platform shoes in the near future.
I thank Susan Riley for extensive help with this column.