Financial markets are signaling growing concerns about inflation as the economy recovers from the Great Virus Crisis. Many experts fear that further increases in the cost of living will result as consumer demand exceeds supply.
On the other hand, the Federal Reserve believes that inflationary pressures caused by a short-term imbalance between demand and supply are transient. But history teaches that inflation fears must be addressed early to avoid serious economic hardship.
As the economy reopens, the danger is that the United States experiences a classic case of too much money for too little commodity. Money printing has become widespread and the money that was left in people’s bank accounts can finally be spent.
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Supply has been limited by holidays, mask wear, social distancing and other policies aimed at containing the pandemic. The Fed’s position is that recent increases in the prices of food, building materials, used cars and gasoline, along with scattered labor shortages and soaring house prices, will fade quickly after the pandemic.
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But the Fed flooding the economy with massive amounts of liquidity could pave the way for a possible price spike, fueling inflation. These fears are rooted in the 1970s, when the United States experienced a period of double-digit inflation that left painful memories for Americans who experienced the so-called Great Inflation.
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During this period, inflation fell from a negligible rate of 1.6% in 1965 to 13.5% in 1980. Stable prices give people a sense of security. They are like safe streets and clean drinking water. During the Great Inflation, people couldn’t predict whether their wages would keep pace with the sharp price increases that had become the norm.
Inflation has been blamed on factors such as President Nixon who suspended convertibility of the dollar into gold, which caused the dollar’s value to fall and import prices to rise; two oil shocks; the massive cost of the Vietnam War; monetary policy errors; and the breakup of the Beatles.
People started to expect continuous price increases, so they bought more products. The increase in demand pushed up prices, leading to demands for higher wages, which triggered even higher prices, causing a continuous upward spiral.
For example, employment contracts increasingly included automatic cost of living clauses that contributed to the inflationary spiral of wages and prices, and the government began to peg certain payments, such as social security, to the consumer price index, the best-known indicator of inflation. While these practices may have helped workers and retirees cope with inflation, they also perpetuated it.
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The government’s ever-increasing revenue requirements have increased the federal budget deficit and led to increased government borrowing, which has pushed up interest rates and costs to businesses and consumers. With energy costs and high interest rates, business investment languished and unemployment exceeded 10%. The simultaneous inflation and recession that followed destroyed many businesses and injured countless Americans.
The Fed took drastic action in the late 1970s and early 1980s, tightening monetary policy under legendary President Paul Volcker to promote price stability and combat the persistent surge in inflation. As a result, the federal funds rate fell from 10% in early 1979 to 19% in mid-1981. The unemployment rate peaked at 10.8% at the end of 1982.
During this severe recession, thousands of businesses failed because they did not have access to capital, and credit-dependent sectors of the economy, such as the sale of homes and cars, suffered greatly. Volcker’s restrictive monetary policy was a tough pill to swallow, but it ultimately had the desired effect. In the mid-1980s, inflation fell below 5%.
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The story of the Great Inflation holds many important lessons for the future. The first is that rising prices should be nipped in the bud, as there is no quick and painless solution to soaring inflation. The longer you wait to deal with it, the more difficult it becomes.
As economist and philosopher Friedrich Hayek once said, “Taming inflation is like catching a tiger by the tail.”
Joseph M. Giglio is Professor of Strategic Management at Northeastern University D’Amore-McKim School of Business.