I’m not a big fan of the Federal Reserve’s current policy choices.
They obviously had to do something about the persistently high inflation, but I think they run the risk of overdoing it. The magnitude of their rate hike increases the risk that something in the financial system will break.
The Fed is in a tough spot because it acted too late, but also because they don’t want inflation to get so bad that it makes them drop the hammer even harder.
One of the biggest reasons the Fed is going so hard on the finish line here is that they don’t want a repeat of the 1970s, when inflation stayed consistently high throughout the decade.
Jerome Powell said as much to the House Financial Services Committee when he commented that the situation of the 1970s is, “We’re trying not to repeat it.”
Treasury Secretary Janet Yellen said something similar: “I came of age and studied economics in the 1970s, and I remember what a terrible time it was. Nobody wants to see this happen again.”
Between 1970 and 1981, the average inflation rate in the United States was almost 8 percent per year. There were four recessions during that period, and the final one dealt the death blow to the inflationary beast.
I don’t agree with the idea that we are preparing for a repeat of the 1970s, but there are some parallels.
In both periods, public spending increased and the money supply grew. In both episodes, there was a shortage of food and energy. And both seasons came with rapid salary increases.
Wage growth is probably the thing the Fed is most concerned about. After all, one person’s income is another person’s expense.
If we compare the change in average hourly earnings to headline inflation over a decade, you’ll see a strong relationship between wages and prices:
Until the end of September, average wages have already risen by almost 17% this decade. That’s almost as much as the entire 2010s in less than three years. The consumer price index has risen only 16% in the 2020s, so the relationship seems to continue.
So it’s not like the Fed’s fears are completely unfounded.
However, there are also many differences.
The simplest reason I believe the inflationary cycle of the 1970s will not repeat itself is that central bank officials have studied that period and the mistakes made by their predecessors.
Just as the reason there was no repeat of the Great Depression of the 2008 crisis is that Fed officials had investigated the mistakes made during that period and by their predecessors.
Our knowledge of the 1970s and the scars it left behind is one of the biggest reasons why we don’t repeat that result.
In the 1960s, economists working for Presidents Kennedy and Johnson adopted an approach they called “fine-tuning.” An economist who served on Johnson’s Council of Economic Advisers wrote, “Recessions are now seen as essentially preventable, like plane crashes and unlike hurricanes.”
This is why they underestimated the impact of Vietnam War spending and Great Society spending programs (Medicare, Medicaid, education, etc.) on inflation, which rose from under 2% in 1960 to over 6%. by the end of the decade.
Most policy makers and politicians were against raising interest rates to a level that would slow down inflation. President Johnson himself once said, “It’s hard for a boy from Texas to ever see high interest rates as a lesser evil than anything else.”
When his Federal Reserve chairman, William McChesney Martin, wanted to take the punch away in 1965, Lyndon Johnson violently declared, “Boys are dying in Vietnam, and Bill Martin doesn’t care!”
The message was received loud and clear. The Fed raised rates slightly, but then lowered them back a few years later.
Arthur Burns headed the US Federal Reserve from 1970 to 1978, when inflation averaged nearly 7 percent per year and rose as high as 12.3 percent. Burns assumed that the central bank could do little to slow inflation by raising interest rates because it could not control the actions of big business or unions.
So he persuaded Richard Nixon to impose wage and price regulation in the early 1970s.
It did not work.
Nixon kept pushing Burns to keep interest rates low despite the ever-rising inflation, not wanting to blame anyone for causing the recession.
When Gerald Ford became president, he emphasized inflation, but telling Americans to plant vegetable gardens, wear sweaters to save energy, and carpool to work didn’t help.
When Jimmy Carter became president in 1976, he wanted to fight inflation with economic growth, saying, “My own belief is that the best way to control inflation is not to make money scarce.”
When he realized that inflation wasn’t going away toward the end of his first and only term in office, Carter basically told Americans to stop buying things.
Good luck with that.
According to Robert Samuelson, the US money supply grew by 23% in the 1950s, 44% in the 1960s, and 78% in the 1970s.
It wasn’t until Paul Volcker took over as Fed chairman in 1979 that someone decided enough was enough. He quickly raised the Fed Funds rate from 10% to over 20%, causing two recessions in three years and sending the unemployment rate into double digits.
In the 1960s, the Federal Reserve decided that jobs were more important than inflation. As we reached the early 1980s, Volcker decided that controlling inflation was more important than jobs.
Interestingly, the Fed’s current system has gone through a similar cycle, except it happened in two years, not 20 years.
After the pandemic, Jerome Powell and company decided getting people back to work was their number one priority. And it worked:
Now the Fed has shifted its focus from the labor market to inflation. It hasn’t worked yet, but these things usually work with a delay.
Look at how quickly money growth has collapsed after the huge spike in consumption caused by the pandemic:
It took a while for that initial increase in the money supply to turn into inflation, so it will likely take a while for the reversal to happen as well.
While we’ve seen oil prices rise in recent years, it’s nowhere near the change people had to deal with in the 1970s:
The price of oil rose from about $2 a barrel in the early 1970s to $34 a barrel by 1981. That’s a 17-fold increase in price.1 The price of oil was around 60 dollars per barrel in the 2020s. To match the rise of the 1970s, it would have to go above $1,000 a barrel.
I guess anything is possible, but it seems unreasonable. In the 1970s, you had the end of Bretton Woods, when Nixon suspended the exchange of dollars for gold. There was the oil embargo in 1973 and the Iranian revolution in 1979.
Today we have a war in Ukraine, but we also have OPEC and the US shale industry. There are no queues at the gas station like in the 70s.
Energy was also a much larger share of household budgets in the 1970s than today:
There are also other long-term structural forces here that make a repeat of 1970s-style inflation unlikely.
Technology is a deflationary force, and this sector now makes up a much larger share of the economic pie than it did then.
A lot of people are worried about globalization following all the pandemic supply chain issues, but it’s not like we’re going back to what it was like in the 70s.
In addition, you have an aging population across the developed world.
Yes, the largest demographic in the U.S.—millennials—are in their prime household formation years, just as the boomers were in the 1970s.
But when the first wave of baby boomers started working and spending their years, there was no second generation to offset those expenses. Boomers surpassed all other demographics.
We have never had an aging population as large as baby boomers. This should help smooth out millennials hitting their prime. Millennials have a counter-force that boomers didn’t have in the 1970s.
Inflation may of course remain stubbornly high in the short to medium term, but I don’t see a repeat of the 1970s coming into the 2020s.
The Fed is as far ahead of this problem as it was then.
We learned our lesson from that terrible period of stagflation.
And there are long-term trends that should moderate inflation in the long run.
What would you do if you were running the Fed right now?
1I’m not usually a log scale chart, but it clearly shows the massive relative change in oil prices since the 1970s.
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