Previously published on January 10, 2022 in
By Milton Ezrati, Chief Economist at Vested
Most references to the last great inflation center on the 1973 Arab oil embargo. That is hardly surprising. The embargo was dramatic and did contribute mightily to the pace of inflation, at least for a time. But the great inflation of that time had other, more fundamental roots. They began to create inflationary pressures long before the embargo and they offer considerable and not very encouraging perspectives on what is happening today.
The severe inflation problems associated with the 1970s began almost a decade before the oil troubles of painful memory. First signs of the price pressure emerged as early as 1965. After years of barely any inflation, consumer prices that year rose by about 2.0%, hardly frightening by today’s standards and certainly by the standards of what was about to happen, but a big change from inflation of 1.3% or less that had prevailed for some time. In 1966 consumer prices rose 3.5% and then built on themselves so that by 1969 they were rising at a 6.0% annual rate.
This initial price pressure had two clear roots. One was the strain President Lyndon Johnson had placed on the federal budget and the economy by simultaneously pursuing a war in Vietnam and a domestic war on poverty. Second was the willingness of Federal Reserve (Fed) to accommodate the government’s credit needs by creating a powerful flow of new money. The broad, M2 measure of the nation’s money supply rose a rapid 8.0% a year on average during this time.
When in 1969 Nixon took office, he continued to spend freely, even though the war in Vietnam had begun to wind down. That alone would have kept up the inflationary pressure, but Nixon added something new into the mix. In August 1971, he ended the dollar’s convertibility to gold. This move destroyed the fixed exchange rate system that had prevailed for decades. The dollar fell on global exchange markets, raising the price of imports and adding directly to American living costs. More fundamentally, the break with gold removed any restraint on the Fed’s ability to create new money. Growth in the country’s money supply soared at rates approaching 12% a year on average between 1971 and 1973. Along with federal spending, this abundant flow of money boosted buying, adding to the inflationary trend, bringing consumer price inflation up quickly from a brief pause during the mild 1971 recession.
By 1973, the members of the Organization of Petroleum Exporting Countries (OPEC) had begun to chafe over how the American inflation was eroding the real value of their product. While other prices were rising, oil, set by American interests, had held at a relatively steady $25.00 a barrel. Late that year, OPEC took control of pricing by imposing an embargo on oil sales and then quadrupled prices.
The Fed compounded the inflationary pressure by pouring still more money into the economy. The broad money supply jumped 14% in 1974. The Fed intended that this monetary ease would relieve the economic strains of high oil prices, but the added money mostly extended and enlarged the immediate inflationary impact of the one-time jump in oil prices. By early 1975, inflation was running at over 11% a year.
Consumer price inflation continued to build, and by 1979 it verged on a 14% yearly rate, sustained by the cumulative effect of the Fed’s money creation and a second round of oil price increases connected to that year’s Iranian revolution. By then, the economic harm of inflation had become widespread and well known. Because stocks and bonds are denominated in dollars that were rapidly losing buying power, prices in financial markets crashed. More generally, inflation, by skewing notions of value, distorted investment incentives and confused planning so that the capital spending that would otherwise have fostered growth fell far short of what the country needed. With the Fed accommodating inflation, all expected price pressures to continue. Workers made wage demands on the expectation of rapid increases in the cost of living and managements granted them on the expectation that they could easily raise prices to more than offset the impact on the bottom line. This so-called wage-price spiral gave inflation a life of its own even as workers fell further and further behind. All suffered.
The end came when a new Fed chairman, Paul Volcker, refused to validate the inflation as the Fed had previously done. He cut the pace of money growth. Without a ready source of Fed-provided liquidity, interest rates spiked upward. The 10-year treasury yield briefly hit 16%, and short-term rates rose to 21%. Amid the pain of these responses, the Fed’s actions broke the inflationary spiral. By 1983, almost 20 years after the process had started, consumer price inflation had fallen below 3.0% a year.
Though much today is different, much also looks like this past. Washington is spending — even more aggressively than it did then. The Fed similarly has also pursed an expansive monetary policy. Recently monetary policy makers promised a more restrictive posture but announced plans for only the most gradual of moves. The U.S. economy may get lucky, but the picture looks disturbingly like it did last time.