America’s not-so-great inflation

Barry Eichengreen February 11, 2022 10:48

It has become abundantly clear that the United States has an inflation problem. What is not yet clear is how big the problem will turn out to be and how long it will last.

Alarmed observers point to parallels with the 1970s, when commodity prices shot up, the US Federal Reserve fell behind the curve, and inflation expectations became unmoored. Consumers, producers, and workers all expected prices to keep rising at the same or even an accelerating pace. Accordingly, households adjusted their spending, unions their wage demands, and businesses their prices, triggering an inflationary spiral.

Today, in contrast, inflation expectations remain firmly anchored. The Michigan Survey of Consumers shows that respondents expect inflation to approach 5% over the coming year, before falling back to just above 2% in the subsequent four years. The inflation rate implicit in the price of five-year inflation-indexed Treasury securities shows basically the same thing: inflation averaging 2.8% over the next five years. We can infer that expected inflation for the years 2023 to 2026 is below this five-year average, given the expectation of 5% for 2022. There is no sign of the ship dragging anchor, in other words.

Things can always change, of course. The question is whether inflation expectations, however stable they might be for the moment, will remain equally well anchored in the future, or whether they will become unmoored, as they did in the 1970s.

Answering that question requires ascertaining whether the conditions leading to the 1970s “Great Inflation” have really been consigned to the dustbin of history. Importantly, in 1973, when consumer price inflation reached 6%, it was entirely rational for consumers, producers, and workers to extrapolate that rate into the future. They were justified in thinking that inflation would persist, because there were absolutely no grounds for believing that the Federal Reserve would tamp it down.

The Fed, or at least those responsible for its policies, did not even possess a model of the connections between central-bank policy and inflation. The closest thing to an anchor for policy in the 1950s and early 1960s was the Bretton Woods international monetary system. Under Bretton Woods, the US pegged the dollar to gold at $35 an ounce, and foreign central banks and governments could redeem their dollars for gold, on demand.

Excessive inflation and lax central-bank policy might jeopardize this commitment. If US interest rates were too low, capital would flee the country, gold would be lost, and the Fed would be forced to raise rates in response. If spending was too strong, imports would surge, gold would again be lost, and the Fed would have to rein in demand. The Fed was not targeting inflation, and it was not seeking to minimize unemployment. Its mission was to conserve US gold reserves and defend the dollar’s Bretton Woods peg.

It is commonplace to attribute the Great Inflation to the collapse of Bretton Woods in 1971-73. In fact, Bretton Woods had already lost its bite, and inflation had begun to accelerate in the second half of the 1960s. The US adopted policies, such as an Interest Equalization Tax on American foreign financial investments, that loosened the link between inflation and gold losses. The Treasury Department asserted its responsibility for managing the foreign-exchange market, allowing the Fed to dismiss gold losses and dollar weakness as someone else’s problem. As a result, US inflation was approaching 6% already in 1970, even before the collapse of Bretton Woods.

The demise of Bretton Woods would not have mattered had the Fed possessed a coherent theory connecting monetary policy with inflation. In lieu of that was Chairman Arthur Burns’s view that monetary policy didn’t matter. Burns believed that inflation was caused by unions’ excessive wage demands, price increases by firms with market power, poor harvests, high oil prices, and excessive government spending. His successor, G. William Miller, lacked Burns’s academic credentials and was not inclined to question the views of his illustrious predecessor. Paul Volcker eventually would have something to say about this, but not until after he became Fed chair in 1979.

Today’s circumstances could not be more different. Fed officials understand that, in all but the most exceptional circumstances, monetary policy and inflation are intertwined. They have a coherent policy framework, average inflation targeting, to which they are committed. Financial-market participants and survey respondents alike show every sign of believing them.

Nonetheless, the Fed has a rocky road ahead. Interest-rate hikes can roil financial markets and provoke capital outflows and debt difficulties in emerging economies. Such are the consequences of falling behind the curve. But, in contrast to the 1970s, the Fed knows what is at stake. Having fallen behind, it is now firmly committed to catching up.

Copyright: Project Syndicate
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Barry Eichengreen

The writer, a Center for International Governance Innovation fellow, is a professor at the University of Cambridge and the University of California, Berkeley.