Is Inflation Really Dead?
Inflation seems like a relic of a former age. It began to creep up on us during the Vietnam war era in the late 1960’s. An economic slowdown in 1968 brought it down but it came roaring back quickly leading President Nixon to introduce price controls when inflation exceeded 5%. The energy price shocks in the 1970s led to inflation outbursts, each one higher than the last and reaching a peak of about 15% in 1980. By that time the country was in despair as double-digit inflation made business and personal planning difficult and fraught with uncertainty. The nightmare came to an end with the appointment of Paul Volcker to lead the Federal Reserve by President Carter. A dramatic change in monetary policy led quickly to the deepest recession of the post-war period until the Great Financial Crisis and the resounding defeat of Carter in the 1980 election. Finally, by the mid-1980’s, inflation was largely tamed. (see CHART 1)
CHART 1 • THE GREAT INFLATION
You would have to be an aging baby boomer to have any memory at all of the inflationary experience that seriously disrupted the American economy a generation ago. The millennial generation, born as it ended, has no experience with inflation. Concern about the looming threat of inflation is shrugged off by a generation that does not have any experience to provide reason for concern (see CHART 2).
CHART 2 • THE GREAT MODERATION AND BEYOND
It is dangerous to forget the lessons of history. As a baby boomer, I tired quickly of my father’s warnings about the Great Depression – ‘turn off the lights, turn down the heat, you don’t know what it was like during the Depression.’ The Depression did not seem particularly relevant to my generation and many lessons of that era that were forgotten by policy makers which helped sow the seeds of the financial crisis in 2008.
Is a punishing inflation really out of the picture? Or have the millennials just forgotten about the history that they never experienced?
Our most important policy makers – President Biden, Treasury Secretary Yellen, Fed Chair Powell – are aging baby boomers who surely remember the Great Inflation. They tell us as much but they also tell us that there are strong and convincing reasons why inflation is not a problem.
Are things really different now? Or have we just forgotten the experiences of the baby boomers almost 50 years ago?
There is simply no evidence of inflation perking up once again. There are three occasions in the last 50 years when the US unemployment rate dipped below 4% -- in 1969, 2000 and 2019. In the first instance, inflation doubled; in the second it nudged up a percentage point and most recently it did not budge.
In the 21st century inflation does not respond to changes in economic conditions. There are a few reasons for this, starting with globalization. A global marketplace creates competitive pressures on American producers and workers that holds down inflation. Firms cannot increase prices when foreign competitors are breathing down their necks.
Moreover, inflation does not budge because expectations about future inflation are so firmly anchored. Price setters will not build-in price increases if they are convinced that there will not be any inflation, and that their competitors share that belief. Strongly held expectations are self-fulfilling.
Expectations are measured either from surveys of individuals or inferred from financial markets. CHART 3 shows two familiar measures. The blue line is the one year expected inflation rate from the Survey Research Center at the University of Michigan. The red line is the five-year ahead five-year expectation of inflation derived from financial market data. Longer term expectations have never exceeded 3% and have been below the Fed’s 2% inflation target in most recent years. The survey of individuals suggests inflation expectations have hovered around 3% for 30 years and have declined recently as the economy expanded.
CHART 3 • INFLATION EXPECTATIONS
Next, this time might be different because there are strong reasons why expectations are so firmly anchored. The Federal Reserve addresses its price stability mandate very differently now than it did during the Great Inflation. The Fed now specifies its inflation target – 2%-- and makes clear its commitment to have policy guided by that target. Further, confidence in the leadership of the Fed and its independence to act make the commitment credible.
A related issue is the role of monetary expansion. In the 1970s the link between money supply growth and inflation was much stronger than it is now and the Federal Reserve often lacked the tools or the willingness to control money expansion. Rounds of QE during and after the financial crisis led to large increases in the monetary base which were recently eclipsed by the credit expansion of the pandemic. However, the financial structure is now different. The Fed pays interest on reserves which neutralizes their impact. What’s more, the Fed stands ready to reverse the growth in the monetary base if credit expansion becomes inflationary.
Finally, there are some reasons long-term inflation will be restrained as a result of widely anticipated structural changes in the economy. It takes a long time for new technologies to move into the work place, change the way we do things and impact productivity. Electricity started to light things up late in the 19th century but it did not dramatically change the way businesses operate until the booming 1920s. Computers appeared on office desks in the 1980s but did not revolutionize the way we conduct our lives until the start of the 21st century. Similarly, artificial intelligence will make self-driving cars a reality and impact productivity and labor in many other ways over the next few decades. Such technological innovation will spur rapid growth and mitigate any inflationary pressures.
All in all, there might well be reason why there is so little concern about inflation. All of the economic expansions in the last 25 years have taken place without a hint of inflation. There is no reason think that the post-pandemic expansion will be any different. Policy makers are wiser and more able and willing to respond if inflation emerges. Further, the public is convinced that these commitments and capabilities are real which anchors expectations and holds inflation at bay. And finally, the longer-term prospects of technology-driven productivity growth provides reason for continued confidence.
So why do I keep thinking of my father and his Depression mentality that I mocked as a teenager? Because the lack of historical experience can let us put our guard down. Policy mistakes can happen, the public might resist any unpopular policies that are needed to fight inflation, concern for other important things such as income inequality might hamper policymakers eager to tighten monetary policy. And, if these things happen, then expectations can turn and confidence erode all too quickly. I don’t think it will happen anytime soon but I do think that it is important to make sure that millennials and their successors learn why inflation matters.