Over the past year, the Federal Reserve has been raising short-term interest rates. These rate hikes are designed to prevent inflation from trending upward from the low levels enjoyed by U.S. consumers over the past several years.
Over the past year, the Federal Reserve has been raising short-term interest rates. These rate hikes are designed to prevent inflation from trending upward from the low levels enjoyed by U.S. consumers over the past several years. In light of these actions, it is perhaps worthwhile to reflect on an earlier period of U.S. history when inflation performance was not so good. In this Economic Letter, I review some theories that try to account for the rise of U.S. inflation during the 1960s and 1970s (often referred to as the “Great Inflation”) and the abrupt disinflation in the early 1980s.
A satisfactory theory of the historical pattern should address the following questions:
- Why did events happen when they did? In other words, what was different about the period from 1965 to 1980 that allowed CPI inflation to go from less than 2% to over 12%? Why did the disinflation occur in the early 1980s and not some other period?
- Why do we see a similar historical pattern for inflation in Canada and many European and Pacific Basin countries? What was different about Japan where the disinflation occurred earlier–in the mid-1970s–as opposed to the early 1980s in the other countries?
- Can these events happen again?
Theories about the Great Inflation fall roughly into one of three categories: bad luck theories (which emphasize chance events outside the Fed’s control), policy mistake theories (which emphasize discretionary actions by Fed policymakers), or combination theories (where chance and discretion both play a role).
In work by Orphanides (1999), which is further explored in Lansing (2000), the hypothesis is that Fed policymakers of the 1970s did not know that trend productivity growth, and hence the economy’s sustainable growth rate, slowed dramatically around 1973 for some reason that has yet to be fully understood. One version of the story goes like this: to construct an estimate of the economy’s sustainable growth rate, Fed policymakers fit a trend through the historical data. When incoming data started falling below the fitted trend because of the abrupt productivity slowdown, policymakers interpreted the data as evidence of a severe recession. In an effort to “lean against the wind,” policymakers lowered short-term interest rates. Though well-intentioned, this policy turned out to be overly expansionary because it did not account for the reduction in the economy’s sustainable growth rate. The result was higher inflation. As more data came in over time, policymakers adjusted the fitted trend, improving their estimate of the economy’s sustainable growth rate. However, with interest rates still below previous levels, inflation continued to rise. Eventually, inflation rose to a point where Fed policymakers were motivated to reverse course and start raising interest rates to fight inflation. The momentum in inflation was such that the Fed could not turn things around until the early 1980s.
A problem with this story is the timing of the rise in inflation. The theory ties the rise to the productivity slowdown, but research places the slowdown sometime in the early 1970s, not the mid-1960s, when U.S. inflation actually began to rise. The theory does provide a rationale for the timing of the disinflation, however, as the combination of the Fed’s sluggish learning of the slowdown and the inherent momentum in inflation could explain why it took until 1980 before inflation peaked and started heading back down. The theory also may help explain the similar inflation patterns of other countries because many developed economies experienced productivity slowdowns around the same time. Finally, the theory suggests that the above events, or their mirror image, can happen again. Since 1995, for example, the U.S. economy has experienced a surge in capital investment linked to computers and information technology. Productivity growth has picked up while inflation has declined. These observations have led some economists and policymakers to conclude that another shift in the economy’s sustainable growth rate has occurred, this time in the positive direction. This is the celebrated “new economy” view. Under this interpretation of the theory, incoming real GDP data consistently plots above a fitted trend extrapolated from past data. Policymakers interpret the data as evidence of a boom and raise short-term interest rates to restrain aggregate demand. This, in turn, contributes to lower inflation. In reality, of course, there remains a great deal of uncertainty about whether the U.S. economy’s sustainable growth rate has actually increased.
The chance event of the productivity slowdown also plays a crucial role in work by Braun (1984). In Braun’s model, workers base their real wage demands on productivity growth extrapolated from the past, while firms base their real wage offers on the economy’s true underlying growth rate of productivity. Braun argues that the productivity slowdown of the early 1970s caused workers to bargain for and obtain real wage increases in excess of their true productivity gains. Firms passed along the additional wage costs to consumers in the form of higher prices, thereby setting off a wage-push inflation spiral. In addition to problems explaining the rise of U.S. inflation in the mid-1960s (before the onset of the productivity slowdown), this theory does not explain why workers and firms have different information about the true growth rate of productivity.
Blinder (1982) develops a theory that relies mostly on bad luck. He argues that oil and food price shocks, coupled with pent-up inflation from the release of the Nixon wage-price controls in 1974, can account for most of the rise in inflation during the 1970s. He also argues that the absence of these same factors can account for most of the fall in inflation during the early 1980s. Fed policymakers share part of the blame because they attempted to offset the contractionary effects of the oil shocks with expansionary monetary policy. DeLong (1997) points out two problems with Blinder’s story. First, inflation started rising in the mid-1960s before the first oil shock took place. Second, there is no evidence that the temporary bursts of price inflation from the oil shocks affected the time path of wage inflation–a prerequisite if we are to believe that the oil shocks determined the course of the long-run inflation trend. Taylor (1997) points out that the second oil shock in 1979-1980 did not produce a strong burst of inflation in Japan, lending support to the view that monetary policy, not the oil shocks, was the driving force behind inflation.
Hetzel (1998) and Mayer (1999) take the approach of investigating the views held by Federal Reserve officials during the 1960s and 1970s. Both authors contend that policymakers believed incorrectly that much of the observed inflation was determined by factors outside of the Fed’s control. They also argue that the imposition of wage-price controls in 1971 opened the door to the pursuit of an overly expansionary monetary policy because Fed policymakers believed that the controls would do the job of restraining inflation. These ideas do not explain why inflation started rising in the mid-1960s and leave open the question of what caused Fed policymakers to change their views about inflation.
Other theories emphasize policymakers’ mistaken belief in an exploitable Phillips curve trade-off, i.e., the notion that monetary policy could permanently lower unemployment by generating higher inflation. DeLong (1997) argues that this belief, coupled with a strong aversion to unemployment engendered by the memory of the Great Depression, led policymakers to pursue an ill-fated attempt to drive the unemployment rate below 4% and keep it there. After experiencing the unpleasant effects of high inflation, policymakers reversed course and brought inflation back down.
Taylor (1997) argues that DeLong’s theory does not explain why policymakers waited until the mid-1960s to abandon price stability, as opposed to an earlier period closer to the Great Depression. He further argues that tracing the history of the Phillips curve helps account for both the rise and fall of U.S. inflation. The intellectual development of an exploitable Phillips curve trade-off in the 1960s and its subsequent adoption by policymakers explains why inflation started rising when it did. Some years later, economists Edmund Phelps and Milton Friedman argued persuasively that any such trade-off was bound to be short-lived: once people came to expect the higher inflation, monetary policy could not keep unemployment below its long-run equilibrium, or “natural,” rate. Their claim was later borne out by the experience of the 1970s when rising U.S. inflation did not bring about the lower unemployment rates promised by the Phillips curve. On the contrary, higher inflation coincided with higher unemployment–a combination that became known as “stagflation.” The experience of the 1970s caused policymakers to abandon the notion of an exploitable Phillips curve trade-off. This, together with changing views about the economic costs of reducing inflation, led policymakers to pursue a disinflationary policy by 1980. Taylor’s theory can be applied to other countries as well. Pagan, Gruen, and Thompson (1999) trace the intellectual development of the Phillips curve within the Reserve Bank of Australia and discuss its possible influence on monetary policy.
Sargent (1999) develops a theory that includes some elements from DeLong (1997) and Taylor (1997), and builds on the well-known Kydland-Prescott (1977) model of inflation. In the Kydland-Prescott model, discretionary policymakers are tempted to create surprise inflation in order to temporarily push unemployment below the natural rate. Private sector agents recognize this temptation and adjust their inflation expectations upward accordingly. In equilibrium, no surprises occur but the economy ends up with higher than optimal inflation.
In Sargent’s version, discretionary policymakers choose an inflation rate based on their mistaken belief in an exploitable Phillips curve trade-off. The menu of perceived choices between inflation and unemployment is constructed by fitting a Phillips curve to historical data. Random shocks to the economy may alter the perceived trade-off between the two variables, thereby leading to a small reduction in the inflation rate. This generates new data that alters the perceived trade-off in the next period, and so on. The feedback process eventually causes policymakers to discard their belief in an exploitable trade-off. In such an environment, the optimal policy is clear: reduce inflation. These events happened in the early 1980s by chance, but the initial conditions for the model simulations can be tied to the intellectual development of an exploitable Phillips curve trade-off in the 1960s. Sargent’s theory implies that the reduction in inflation is unlikely to be permanent, however. Even when inflation is low, policymakers continue to update their estimates of the Phillips curve. Eventually, incoming data suggests that it may be possible to exploit a Phillips curve trade-off once again. Private-sector agents adjust their inflation expectations upward accordingly. In this way, inflation can work its way back into the economy.
Parkin (1993) develops a theory that builds on a key feature of the Kydland-Prescott model, namely, that an increase in the natural rate of unemployment leads to an increase in the equilibrium inflation rate, and vice versa. This occurs because changes in the natural rate influence policymakers’ temptation to engage in surprise inflation behavior. Parkin argues that the Kydland-Prescott model predicts rising inflation during the 1960s and 1970s and declining inflation during the 1980s because demographic shifts have created a similar hump-shaped pattern in the natural rate of unemployment. During the 1960s and 1970s, the peak of the baby boom generation was passing through a period of high life-cycle unemployment: the teen years and early twenties. During the 1980s these same individuals took on more stable jobs as they became older. Parkin’s theory has the potential to explain inflation behavior in other countries because population aging patterns in industrialized nations appear to be synchronized. There are several problems however. First, U.S. inflation peaks around 1980 and starts to decline several years before we observe a decline in the U.S. unemployment rate. The theory says that these movements should coincide. Second, as Parkin admits, the Canadian unemployment rate continued to increase throughout the 1980s while Canadian inflation was coming down dramatically. Third, as Taylor (1997) points out, European unemployment also kept rising during the 1980s while inflation was falling.
Understanding the causes of the Great Inflation is important because it can shed light on various aspects of the economy’s behavior that may help improve the conduct of monetary policy in the future. The theories described above focus on a single explanation for the historical episode because researchers wish to isolate the merits and drawbacks of a particular story. Nevertheless, researchers recognize that elements from many different theories could have been (and probably were) operating simultaneously within the U.S. economy.
Kevin J. Lansing
Senior Economist
Blinder, Alan S. 1982. “The Anatomy of Double-Digit Inflation in the 1970s.” In Inflation: Causes and Effects, ed. R. Hall, pp. 261-282. Chicago: Univ. of Chicago Press.
Braun, Steven. 1984. “Productivity and the NIIRU (and Other Phillips Curve Issues).” Board of Governors of the Federal Reserve System, Working Paper 34.
DeLong, J. Bradford. 1997. “America’s Peacetime Inflation: The 1970s.” In Reducing Inflation: Motivation and Strategy, eds. C. Romer and D. Romer, pp. 247-276. Chicago: Univ. of Chicago Press.
Gruen, David, Adrian Pagan, and Christopher Thompson. 1999. “The Phillips Curve in Australia.” Journal of Monetary Economics 44, pp. 223-258.
Hetzel, Robert L. 1998. “Arthur Burns and Inflation.” FRB Richmond Economic Quarterly, pp. 21-44. <http://www.rich.frb.org/eq/pdfs/winter1998/hetzel.pdf> accessed June 2000.
Kydland, Finn E., and Edward C. Prescott. 1977. “Rules Rather than Discretion: The Inconsistency of Optimal Plans.” Journal of Political Economy 85, pp. 473-491.
Lansing, Kevin J. 2000. “Learning about a Shift in Trend Output: Implications for Monetary Policy and Inflation.” Unpublished manuscript. FRB San Francisco. <http://www.sf.frb.org/economic-research/workingp/2000/wpkl00-04.pdf>
Mayer, Thomas. 1999. Monetary Policy and the Great Inflation in the United States. Cheltenham, UK: Edward Elgar.
Orphanides, Athanasios. 1999. “The Quest for Prosperity without Inflation.” Unpublished manuscript. Federal Reserve Board, Division of Monetary Affairs.
Parkin, Michael. 1993. “Inflation in North America.” In Price Stabilization in the 1990s, ed. K. Shigehara, pp. 47-83. London: Macmillan.
Sargent, Thomas J. 1999. The Conquest of American Inflation. Princeton: Princeton Univ. Press.
Taylor, John B. 1997. Comment on “America’s Peacetime Inflation: The 1970s.” In Reducing Inflation: Motivation and Strategy, eds. C. Romer and D. Romer, pp. 276-280. Chicago: Univ. of Chicago Press.
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