Inflation last time – Econlib


In the year to June, the consumer price index rose 9.1%, “the largest 12-month increase since the period ending November 1981.” At the time, the rate was falling from its peak of 14.6% in March and April 1980 and would hit a low of 2.3% in July 1983. What caused this inflation? How was it slowed down?

In the 1960s, monetary policy was based on a concept called the Phillips curve. He argued that there was an inverse relationship between inflation and unemployment, so that when one rose, the other fell. Policymakers could buy lower unemployment at the cost of higher inflation and vice versa.

In the late 1960s, this relationship broke down. The inflation rate rose from 1.6% in 1965 to 5.9% in 1970, but unemployment also rose, from 3.5% in 1969 to 6.0% in 1971. The Chairman of the Reserve federal government, Arthur Burns, complained:

“The rules of the economy don’t quite work the way they used to. Despite significant unemployment in our country, increases in wage rates have not slowed down. Despite unused industrial capacity, commodity prices continue to rise rapidly.

In 1971, President Nixon imposed wage and price controls, but inflation continued to rise. The CPI rose 11.0% in 1974 and President Ford launched the “Whip Inflation Now” – WIN – campaign, the most memorable element of which was the wearing of badges reading “WIN”. And unemployment continued to rise, reaching 8.5% in 1975. In 1978, with inflation at 7.6%, President Carter said:

“Inflation is obviously a serious problem. What is the solution? I don’t have all the answers. Nobody does. Perhaps there is no complete and adequate answer.

It wasn’t quite true. Based on his monumental study with Anna J. Schwartz, A monetary history of the United States, 1867-1960Economist Milton Friedman – who exposed the Phillips curve fallacy in 1968 – had long argued that:

“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can only be produced by a faster increase in the quantity of money than in production.”

Friedman dismissed popular bogies of inflation, including energy price hikes by “Arab sheikhs and OPEC:”

“They imposed high costs on us. The sharp rise in the price of oil reduced the amount of goods and services we could use because we had to export more overseas to pay for the oil. The reduction in production has raised the price level. But it was a once and for all effect. It did not produce a more lasting effect on the rate of inflation from this higher price level.

He contrasted the low inflation of Germany and Japan, which imported all their energy, with the high inflation of the United States, “which is only 50% dependent, or… on the United Kingdom, which has become a major oil producer.

The key variable was monetary policy. Inflation was not an impenetrable mystery: it resulted from the printing of money at a faster rate than the expansion of the real economy. It follows that if you controlled the rate of growth of the quantity of money, you could control inflation.

In July 1979 Carter appointed Paul Volcker as Fed Chairman. He knew what he was getting. When they first met, Volcker told the president “You have to understand, if you appoint me, I favor a stricter policy than [his predecessor].”

Volcker kept his word. In October, he initiated a fundamental shift in Fed policy. Changes in the daily level of the fed funds rate “tended to be too low, too late to influence expectations,” Volcker recalled, “we needed a new approach.”

“Put simply, we would control the quantity of money (money supply) rather than the price of money (interest rates). The widely quoted adage that inflation is a matter of “too much money for too few goods” promised a clear, if oversimplified, rationale.

Interest rates would fluctuate, and as monetary growth slowed, rates would rise: three-month Treasury bill rates were over 17%; the prime rate of commercial banks reached 21.5%; mortgage rates were approaching 18%.

The consequences were brutal. Real GDP fell at an annual rate of 2.1% in the second quarter of 1980 and the unemployment rate rose from 5.6% in May 1979 to a peak of 10.8% in November and December 1982. Credit Carter, unlike his predecessors, did not push Volcker to ease his policies even as he entered an election year. Ronald Reagan defeated him in a landslide.

Volcker had once advised Nixon, “If you have to have a recession, take it early. Reagan did it and reaped the rewards. Real GDP growth hit 7.2% in 1984, the inflation rate fell to 1.9% in 1986, and unemployment fell to 5.3% in 1989. It was “Morning in America,” said Reagan, and he was overwhelmingly re-elected.

Then, like now, “it’s the money supply, silly”.


John Phelan is an economist at the Center of the American Experiment.

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