What Happened Last Time Is Not Encouraging

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Most of the references to the last great inflation center on the 1973 Arab oil embargo. This is hardly surprising. The ban was dramatic and contributed powerfully to the pace of inflation, at least for a time. But the great inflation of the time had other, more fundamental roots. They started building inflationary pressures long before the ban and they offer a very encouraging outlook on what is happening today.

The serious inflation problem associated with the 1970s began nearly a decade before the oil trouble of painful memory. The first signs of price pressure appeared in 1965. After years of barely any inflation, consumer prices rose by about 2.0% that year, hardly appalling by today’s standards and certainly by the standards of what was about to happen, but a big change from 1.3% or so. Low inflation which prevailed for some time. Consumer prices increased by 3.5% in 1966 and then built on themselves so that by 1969 they were growing at a 6.0% annual rate.

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This initial price pressure had two clear roots. A pressure President Lyndon Johnson placed on the federal budget and economy by simultaneously pursuing a domestic war on poverty and war in Vietnam. Second, the Federal Reserve (Fed) wanted to accommodate the government’s credit needs by creating a powerful influx of new money. The broad, M2 measure of the country’s money supply grew at an average rate of 8.0% per year during this period.

When Nixon took office in 1969, he continued to spend independently, even as the war in Vietnam had just begun to end. That alone would have sustained inflationary pressures, but Nixon added something new to the mix. In August 1971, he abolished the convertibility of the dollar into gold. The move destroyed the decades-old fixed exchange rate system. The dollar fell on global exchange markets, increasing the price of imports and directly increasing the US cost of living. More fundamentally, the break with gold removed any restrictions on the Fed’s ability to create new money. Growth in the country’s money supply grew at an average rate of 12% per year between 1971 and 1973. Along with federal spending, this abundant inflow of money fueled purchases, adding to the inflationary trend, bringing consumer price inflation to a brief halt early during the mild recession of 1971.

By 1973, members of the Organization of the Petroleum Exporting Countries (OPEC) had begun quarreling over how US inflation was reducing the real value of their product. While other prices were rising, oil, determined by US interests, was at a relatively stable $25.00 a barrel. Later that year, OPEC took control of pricing by banning oil sales and then quadrupling prices.

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The Fed exacerbated inflationary pressures by injecting more money into the economy. In 1974 the broad money supply increased by 14%. The Fed intended that this monetary easing would offset the economic stress of high oil prices, but the additional funding only exacerbated and exacerbated the immediate inflationary effects of a one-time jump in oil prices. By early 1975, inflation was running at over 11% a year.

Consumer price inflation continued to build up, reaching a 14% annual rate by 1979, sustained by the cumulative effect of the Fed’s wealth creation and the second round of oil price increases associated with that year’s Iranian Revolution. By then, the economic damage of inflation had become widespread and well known. Because stocks and bonds that are denominated in dollars were rapidly losing purchasing power, prices in the financial markets crashed. More generally, inflation, by distorting perceptions of value, distorted investment incentives and confused planning so that capital expenditures that would have otherwise fueled growth fell far short of what the country needed. With the Fed adjusting for inflation, all expected price pressure to continue. Workers demanded wages on the expectation of a rapid rise in the cost of living, and management approved them on the hope that they could more easily raise prices to more than offset the effect on the bottom line. This so-called wage-price spiral gave inflation its life, even as workers fell back and forth. Everyone had to suffer.

The end came when a new Fed chairman, Paul Volcker, refused to validate inflation as the Fed had done before. They cut down on the pace of wealth growth. Without a ready source of liquidity provided by the Fed, interest rates moved upward. The 10-year Treasury yield briefly hit 16%, and short-term rates rose to 21%. Amidst the pain of these reactions, the Fed’s actions broke the inflationary spiral. By 1983, nearly 20 years after the process began, consumer price inflation had fallen below 3.0% annually.

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Although a lot is different today, much still resembles this past. Washington is spending — even more aggressively than that. Similarly, the Fed has pursued a broad monetary policy. Recently monetary policymakers promised a more restrictive currency, but only announced plans for the most gradual moves. The US economy may be lucky, but the picture looks as troubling as last time.

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