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Is Inflation Here to Stay?

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Is Inflation Here to Stay?

Some conditions are right for a repeat of the persistent rising prices of the 1970s. August 11, 2021
Economy, finance, and budgets

Like many Americans, I am experiencing something new these days. Inflation is here: prices are up 5.4 percent from a year ago, according to the Labor Department’s newest CPI numbers. This is more than just a statistic. We can see it in signs in a coffee shop announcing a 10 percent price increase. Dinner out seems to be taking up a larger share of the budget. So are groceries. The oven I bought in March now costs 10 percent more.

The hot question is whether this a new way of life or just a re-opening blip. In 2008, many economists warned that so much loose monetary policy and government spending could spark inflation. It never came, but a generation of pundits and forecasters started to distrust anyone who worried about it. True, some predictions were over the top. But some concerns were valid. If you build a house near a fault line and an earthquake doesn’t happen, that doesn’t mean locating that house there was a good idea.

The year 2008 turned out to be non-inflationary for many reasons. The fiscal stimulus was merely big, not huge. The financial crisis had damaged consumer balance sheets, so households weren’t able to spend much. And the Fed started paying interest on the reserves that banks kept at its regional banks, which tamped down on inflation somewhat.

Yet, we have reasons to believe that this moment is more like the 1970s, when inflation averaged more than 5 percent annually and was so volatile that it topped 13 percent by 1980. First of all, last year’s recession was more of a supply shock than a demand shock. We shut down large swaths of the economy for many months. Unlike the 2008 recession, the 1974 recession also involved a supply shock, in the form of high oil prices resulting from the OPEC embargo, which caused shortages. This rippled across the economy, making goods more expensive, just as shortages on many goods do now.

The embargo ended, but inflation remained. A supply shock is not a sufficient condition for sustained inflation, but it can help produce it when conditions are right. Those conditions take hold when inflation expectations become unanchored. A big driver of inflation, economists believe, is people’s expectations for it. We plan purchases and set wages based on those expectations, so inflation, even if its initial causes are temporary, can become self-propagating if people think it will stick around or make long-term commitments on short-term price changes. People observed rising prices from the shock in the 1970s and expected inflation to stay high.

They believed this partly because they had little faith that anything could be done about it. Wage and price controls designed to fight inflation in the 1960s had proved harmful and ineffective. The Federal Reserve hiked interest rates, but not enough to bring down inflation. Worse, in 1971, the U.S. abandoned the Bretton Woods regime, which had tied the dollar to gold. This created some uncertainty around the dollar and the credibility of the Fed.

Then along came Paul Volcker, appointed Fed chairman by President Jimmy Carter in 1979, who raised rates high and long enough. He showed markets and consumers that the Fed did have the tools—and most critically the will—to fight inflation, even if it meant triggering a recession, which it did. Most importantly, Volker proved that the Fed was independent from politics and fully committed to its objectives. This made markets believe that, even without Bretton Woods, the dollar was a stable source of value. There have been oil-price spikes since the 1970s but not inflation in large part because of a collective belief that the Federal Reserve would do something about it.

Now, once again, we are experiencing a supply shock. Even if oil prices are not the direct cause, that makes this recession more like the 1970s than 2008. The supply shock means we are seeing high inflation, which we didn’t in 2008, and that alone can destabilize expectations. The Fed’s credibility may also resemble the post-Bretton Woods regime more than it does the post-Volcker era. It is hard to imagine that the Fed, with all its new political objectives, would take the economy into a Volcker-style recession to combat inflation. With such high levels of debt, it is questionable whether the Fed could raise rates sufficiently. And, as in the 1960s, some of its new tools—forward guidance and quantitative easing—may not be as powerful as it hopes, and their shortcomings may further undermine the institution’s credibility.

Does this mean high inflation is inevitable? One big difference between the 1970s and now is that we’re just coming off a long period of low inflation; generations of Americans expect inflation to fall because it always has in the past. So, the supply constraints may work themselves out, the Fed may signal that it will take inflation seriously, and markets may choose to believe it—if for no other reasons than self-preservation and a lack of imagination about a risk no one has experienced in recent memory. But the worry about high, persistent inflation is real, because we are re-living the 1970s more than we are re-living 2008.

Photo: Nuthawut Somsuk/iStock

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