Back to the Future? Lessons from the “Great Inflation”

Back to the Future? Lessons from the “Great Inflation”

link to page 1

July 28, 2022
Back to the Future? Lessons from the “Great Inflation”
Since April 2021, the U.S. economy has grappled with high
averaging less than 4% in 2022, the relationship between
inflation, which reached 6.3% in May 2022, as measured by
tight labor markets and rising high inflation has resurfaced.
the Personal Consumption Expenditures (PCE) index. (For
more information, see CRS Report R46890, Inflation in the
High Inflation Can Become Entrenched
Wake of COVID-19.) Many have drawn parallels between
NAIRU theory predicted that inflation would fall once
the current situation and the “Great Inflation”—the period
unemployment rises above the NAIRU. However, while
of high inflation from the mid-1960s to early 1980s, as
inflation fell following recessions beginning in 1970, 1973,
shown in Figure 1. Annual inflation exceeded 4.5% in
and 1980, it did not reach low levels again until the late
1970 and was around 10.5% in 1974 and 1980—the highest
1980s. Inflation rose from 1976 to 1979, although
in peacetime in the nation’s history. Inflation then began
unemployment remained between 5.7% and 7.8%.
declining rapidly, falling below 4% in 1984 and below 3%
Economists attribute this to increases in the NAIRU and to
from 1992 to 2020. In March 2022, the Fed began raising
individuals beginning to expect that inflation would be
interest rates in an effort to reduce inflation.
high, causing persistently high inflation to be a self-
fulfilling prophecy.
Figure 1. Inflation (PCE), 1960-2022
By contrast, from 1992 to 2020, low inflation expectations
and low inflation perpetuated a mutually reinforcing cycle.
The question of whether inflation expectations will remain
low today—evidence is mixed—is key to how quickly
inflation might fall.
Not Reacting to Price Shocks Can Worsen
Inflation—Sometimes
Oil shocks in 1973 and 1979 caused inflation to reach its
highest points during the Great Inflation. In isolation, a one-
time oil price shock would not result in permanently higher
inflation (i.e., prices continually rising at a faster pace).
And yet inflation remained persistently higher after both
shocks because of monetary policy. The Fed faced a
tradeoff—it could raise interest rates to mitigate the

inflationary effects of the shock or “accommodate”
Source: U.S. Bureau of Economic Analysis (BEA).
inflation to mitigate the negative effects on growth and
As policymakers consider strategies to lower inflation, this
employment. The Fed largely chose the latter option
In Focus compares lessons from the Great Inflation to the
throughout the decade. With high inflation expectations,
present day situation and considers why those lessons may
this strategy caused high energy prices to pass through to
not hold based on experiences in the subsequent 1992-2020
overall inflation.
low inflation era.
By contrast, periodic energy price spikes from 1999 to 2011
Inflation Can Be Triggered by Low Unemployment
did not lead to any lasting increase in overall inflation, even
At the start of the Great Inflation, unemployment dipped as
when interest rates were held at zero from 2008 to 2011.
low as 3.4% and inflation rose from 2.5% to 4.5% in 1968-
(The Fed was generally raising rates during the earlier
1969. Based on this experience, economists theorized that
spikes in that period.) As a result, when supply shocks
there was a non-accelerating inflation rate of
caused by the pandemic caused prices to rise in 2021, the
unemployment (NAIRU) and that inflation would rise when
Fed initially decided to accommodate them on the grounds
unemployment dipped below the NAIRU. But in the low
that price rises were transitory and the Fed should not react
inflation era, low unemployment in 1999-2000, 2006-2007,
to them by raising rates. (See CRS Insight IN11926, Supply
and 2018-2019 did not trigger a sustained increase in
Disruptions and the U.S. Economy.) The Fed may have also
inflation, and policymakers came to view the link as weak.
underestimated the strength of demand, boosted by
monetary and fiscal stimulus, as the economy normalized.
This new view was reflected in the Fed’s 2020 policy shift
Had the Fed given more weight to the lessons of the Great
to no longer raise interest rates solely because
Inflation instead, it might have started raising rates when
unemployment was low. This new policy was in contrast to
inflationary pressures first emerged instead of waiting a
the previous consensus that, to prevent inflation from rising,
year. Even if that had not succeeded in fully containing
the Fed should preemptively raise rates when
unemployment was too low. But with unemployment
https://crsreports.congress.gov

link to page 1 link to page 2
Back to the Future? Lessons from the “Great Inflation”
inflation, it might have resulted in a more gradual and less
without rates becoming much higher. Fed leadership’s June
economically disruptive increase in rates.
projections of the “appropriate” path for interest rates
envision additional rate increases in 2022. Nonetheless,
Only Monetary Policy Effectively Reduced Inflation
their appropriate rate would still be negative in real terms at
Policymakers took several actions to lower inflation during
the end of 2022 even if inflation falls as they forecast. Real
the Great Inflation, but most proved unsuccessful. One of
rates would become slightly positive in 2023 but only
the largest attempts was the price control policy put in place
because they believe that inflation would be low again
by President Nixon during the early 1970s. These controls
(2.6% is the median forecast). Furthermore, they project
froze prices, rents, and earnings until 1974. While the
that low inflation can be restored with unemployment
controls were in place, inflation did fall but then spiked to
remaining below 5%. Skeptics refer to this scenario as the
double-digit rates after the controls were dismantled (see
“immaculate disinflation.”
Figure 1) as pent-up demand put further pressure on low
supply. Other unsuccessful attempts to curb inflation during
Figure 2. Federal Funds Rate, 1960-2022
the Great Inflation included the Whip Inflation Now (WIN)
program under President Ford and credit controls enacted
briefly in 1980 under President Carter. The WIN program
was a set of voluntary measures to encourage lower
spending, and while it initially had public support, the
program was not taken up at a rate high enough to lower
aggregate demand significantly. The 1980 credit controls
restrained the use of spending and investing via credit in an
attempt to lower spending in the economy. During the
months in which the credit controls were in place (March-
July), consumer spending dropped notably and interest rates
became very volatile, in part resulting in a brief recession
from February to July. As with price controls, once the
credit controls were removed, pent-up demand resulted in
an increase in spending, increasing inflationary pressures in
the economy once more.

Source: CRS calculations based on data from Fed and BEA.
It was not until the Federal Reserve began aggressive
Can Inflation Recede Without a Recession?
monetary policy tightening under the leadership of Fed
Chair Paul Volcker (1979-1987) that inflation fell and
The aggressive tightening of monetary policy under
remained low. As a result, most economists credit monetary
Volcker came with the tradeoff of relatively high
policy with ending the Great Inflation.
unemployment that recovered slowly. During the recession
of 1981-1982, inflation decreased by over 6 percentage
Higher Interest Rates May Be Needed
points while unemployment increased by over 3 percentage
In the 1970s experience, inflation did not fall when nominal
points and stood at 10.8% in November 1982. Some
(i.e., not adjusting repayment value for inflation) interest
economists argue that low inflation expectations and the
Fed’s credibility on inflation could not have been restored if
rates were high because real (inflation-adjusted) interest
rates were low. Nominal rates rose at times but not quickly
it had not kept rates high despite rising unemployment.
enough to keep up with inflation (see Figure 2). Thus, real
rates were low or even, at times, negative. The high
Since inflation has risen, the Fed has repeatedly pledged
that it is “strongly committed to returning inflation to its 2%
inflation period eventually ended when Volcker tightened
objective.” If individuals find this pledge credible
monetary policy to the point that real rates were no longer
and
low. The average effective federal funds rate rapidly
inflation expectations remain low, then inflation might be
increased from about 11% when he took office to about
reduced relatively quickly without triggering a recession. If
18% in April 1980. It peaked at over 19%, and the economy
not, inflation may remain high for an extended period of
entered another recession from July 1981 to November
time, at which point a more serious economic slowdown
1982. The federal funds rate remained in double digits until
could become necessary to lower inflation. (See CRS
1982, as inflation had far to fall before price stability was
Insight IN11963, Where Is the U.S. Economy Headed: Soft
restored.
Landing, Hard Landing, or Stagflation?) Unlike the
situation that Chair Volcker faced, inflation expectations
Following the 2008 financial crisis, the Fed faced the
may remain low and stable today because inflation has been
opposite problem—even at zero, nominal rates were not
high for only about a year and was preceded by decades of
low enough to prevent inflation from falling below its 2%
low inflation. The extent to which inflation expectations
target. As a result, its monetary policy strategy emphasized
remain anchored depends in large part on whether, going
raising low inflation over preventing high inflation.
forward, the Fed is willing to raise interest rates as much as
is necessary to rein in inflation. Since the Fed believes it
Interest rates today are much lower than in the 1970s in
can reduce inflation without triggering a recession, its
nominal and real terms. As during the Great Inflation, the
resolve has not yet been tested.
Fed has to date maintained negative real interest rates as
inflation has risen and believes that inflation can be reduced
Marc Labonte, Specialist in Macroeconomic Policy
https://crsreports.congress.gov

Back to the Future? Lessons from the “Great Inflation”

IF12177
Lida R. Weinstock, Analyst Macroeconomic Policy

Disclaimer
This document was prepared by the Congressional Research Service (CRS). CRS serves as nonpartisan shared staff to
congressional committees and Members of Congress. It operates solely at the behest of and under the direction of Congress.
Information in a CRS Report should not be relied upon for purposes other than public understanding of information that has
been provided by CRS to Members of Congress in connection with CRS’s institutional role. CRS Reports, as a work of the
United States Government, are not subject to copyright protection in the United States. Any CRS Report may be
reproduced and distributed in its entirety without permission from CRS. However, as a CRS Report may include
copyrighted images or material from a third party, you may need to obtain the permission of the copyright holder if you
wish to copy or otherwise use copyrighted material.

https://crsreports.congress.gov | IF12177 · VERSION 1 · NEW