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The Great Inflation

Price pressures seem quiet—almost too quiet. In October, the PCE chain price index increased 1.4 percent on a year-over-year basis. This was the 30th consecutive month that changes in the PCE index have remained below the FOMC’s 2 percent inflation target. Even without its volatile food and energy components, the index told a similar tale. The core PCE index increased 1.6 percent (year-over-year) in October, its 31st month below the FOMC’s inflation threshold. Likewise, the Federal Reserve Bank of Dallas’ trimmed-mean PCE index increased 1.7 percent in October, its 31st month below the inflation target. Inflation expectations also seem subdued. As it has over the past 41 months, the Federal Reserve Bank of Cleveland’s measure of inflation expectations continues to anticipate inflation below 2 percent over the next ten years. All is calm; all is bright.

Figure 1: PCE Price Indexes
Figure 2: Ten-Year Expected Inflation

Yet, some people still worry about inflation. They hear faint echoes from the 1960s and 1970s and fear a return. The Great Inflation began in late 1965 and lasted until Federal Reserve Chairman Paul Volcker’s disinflation policies took hold in the early 1980s. Inflation first topped 2 percent in early 1966. In contrast, between 1960 and 1965, inflation had averaged only 1.3 percent with little variation. Over the next fourteen years, inflation ratcheted up in three big movements: It reached 5 percent in early 1970, before subsiding. Inflation then rocketed to double-digit heights in early 1974, before again subsiding. This time, however, the ebb was much less. Inflation then climbed again to double-digit territory in late 1979.

Figure 3: PCE and CPI Price Indexes

Economic historians primarily attribute this episode to an economic framework that downplayed money’s causal role in the inflation process, but a policy preference for low unemployment over low inflation, measurement errors, and political pressures also contributed. By late 1977, worldwide confidence in US monetary policy had evaporated, and the dollar was tumbling against the other major currencies. Still, it took two additional years for the FOMC to forcefully respond.

The line of thinking that led to this framework originated around 1960, when policymakers began to distinguish between demand-pull and cost-push inflation, a paradigm that gave monetary policy a subservient role to fiscal and incomes policies. Demand-pull inflation resulted when aggregate demand, as measured by actual GDP, exceeded aggregate supply, as measured by potential GDP. If the economy operated below its potential, demand-pull inflation could not possibly be the problem. Fiscal policy was to return GDP quickly to its potential growth path and restore full employment by running a budget deficit. Monetary policy was to accommodate fiscal policy by keeping interest rates low. Any inflation that existed when economic activity fell below potential must by definition be of the cost-push variety. Chief among the espoused causes of cost-push inflation were union wage demands, but monopoly pricing, commodity-price shocks, and myriad other ad hoc relative price pressures also contributed. Fiscal and monetary policies could do nothing about cost-push inflation short of pushing the economy into a protracted recession. Eliminating cost-push inflation required the administration to adopt some type of incomes policy. Outside of supporting a fiscal tightening when economic growth exceeded potential, monetary policy had virtually no role in any inflation fight.

Unfortunate as this view of the inflation process was, measurement error made matters worse. Policymakers at the time consistently overestimated the level and growth rate of potential output. Such errors led policymakers to underpredict inflation, to incorrectly attribute any observed inflation to cost-push factors and to maintain an excessively accommodative monetary policy. Given the substantial relative price shocks and structural changes taking place in the early 1970s, it is not surprising that policymakers overestimated the nation’s potential growth path.

Figure 4: Inflation-Unemployment Tradeoff; 1948-2013

Further complicating matters was a policy preference for low unemployment over low inflation. Economists—at least prior to 1970—believed that they could manufacture a lower unemployment rate by accepting a higher inflation rate. Many economists and policymakers, with vivid memories of the Great Depression, believed that unemployment was far more socially disruptive than inflation. Indeed, the Employment Act of 1946 echoed these sentiments and required the federal government to pursue full employment as its primary macroeconomic policy objective. So policymakers were willing to attempt the trade. They could, however, only succeed if the public failed to anticipate future inflation. This may have been the case in the early 1960s, but not by end of the decade. In any event, the tradeoff proved ephemeral.

Moreover, as the public grew savvier about the inflation process, the output and employment costs of any disinflation policy increased, making the administration, Congress, and the Federal Reserve all the more reluctant to incur the costs. With the perception that the economy was often below potential and unemployment was often too high, administrations sometimes exerted pressure on the Federal Reserve to accommodate fiscal expansions by keeping interest rates low. At the time, the Federal Reserve interpreted its independence more narrowly than today, believing it should avoid actions, if at all possible, that might thwart the administration’s policy objectives. Consequently, the FOMC was often overly slow and cautious about tightening monetary policy and quick to reverse course when the unemployment rate rose.

Not until the Volcker chairmanship in 1979 would the Federal Reserve fully recognize inflation as a monetary phenomenon and fully assert its independence to pursue price stability. Ever since, monetary policymakers have attempted to strengthen their credibility by championing central-bank independence, adopting specific inflation objectives, and improving their communications.

The views expressed in this article are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Cleveland, the Federal Reserve System, or any of its staff.

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  • 09.29.22

    Inflation: Drivers and Dynamics Conference 2022

    The Inflation: Drivers and Dynamics 2022 conference, co-sponsored by the Center for Inflation Research and the European Central Bank will take place on September 29-30, 2022 in Cleveland, OH.