Policy failure
Violent as a mugger. Frightening as an armed robber. Deadly as a hit man.
Thus cautioned President Ronald Reagan about the dangers of inflation, which for two decades beginning in the mid-20th century stole purchasing power, vandalized the global financial system and battered financial assets. It wasn’t until a new monetary sheriff, Paul Volcker, laid down the law at the Federal Reserve in the early 1980s that rampant inflation was finally arrested.
Now investors are worried that the mugger-robber-hit man might be released on good behavior in exchange for a more vibrant, fairer, cleaner economy. “Inflategate,” as the Economist newspaper dubbed it, has emerged as a cause célèbre among prognosticators eager to weigh in on what could be a crucial economic variable in coming years.
Concerns that inflation, once liberated from the Fed’s 2% handcuffs, will prove difficult to recapture reflect lingering economic traumas from the socalled Great Inflation to which Reagan referred, a roughly 20-year stretch of fast-rising prices that took root in the mid-1960s.
Over that economically fraught period, consumer prices rose by an average of 6.3% per year, triple the pace of the last quarter century. The late 1960s through the early 1980s was a particularly brutal period, with prices rising at an average rate of 7.4%, including four years of double-digit increases.
The economic damage was immense. “The Great Inflation was the defining macroeconomic event of the second half of the twentieth century,” wrote Michael Bryan of the Federal Reserve Bank of Atlanta. “Over the nearly two decades it lasted, the global monetary system established during World War II was abandoned, there were four economic recessions, two severe energy shortages, and the unprecedented peacetime implementation of wage and price controls.”
The economist Allan Meltzer attributed the Great Inflation to “political choices, analytic errors, and the entrenched belief that inflation would continue.” Writing in 1994, Wharton School professor Jeremy Siegel deemed it “the greatest failure of American macroeconomic policy in the postwar period.”
Bonds performed poorly during the Great Inflation, and stocks did not finally
In a determined effort to lift the U.S. economy out of a malaise that’s lasted for much of the 21st century, Fed Chairman Jerome Powell last year committed the Fed to tolerating inflation above its 2% target for short (but undefined) periods if needed to offset stretches of sub-2% inflation. Since the global financial crisis in 2008, there have been plenty of those sub-2% years.
There is nothing necessarily optimal about a 2% inflation rate.
Inflation was over 2% for all but one year in the 1990s, during which stocks soared, bonds held their own and the economy boomed. Even excluding the Great Inflation, consumer prices rose by at least 3% in 16 of the remaining 53 years since 1948.
It is widely expected that a return to economic normalcy will push consumer prices higher as trillions of storedup consumer dollars are unleashed upon what could be fewer goods and services. The key is whether those price gains are “transitory,” or whether consumers and workers expect them to continue indefinitely, thus triggering a repeat of the Great Inflation’s self-perpetuating wage-and-price spiral.
Anybody’s guess
There are innumerable variables that make the current calculus unusually complex.
But today’s economy is different from the 1960s: growth is slower, unemployment higher and labor unions weaker. The U.S. is less vulnerable to the energy embargoes that twice drove up consumer inflation in the 1970s. Technology, globalization and demographics exert downward pressure on prices. And unlike the early 1970s, the Powell-led Fed has resisted political pressure.
Letting inflation out on parole is risky business. If inflationary expectations were to run rampant, the Fed would need to play the tough cop, likely causing a recession. Still, inflation has been too low for too long.
We’re told that rehabilitated offenders can reform and become productive members of society. After four decades under lock and key, we’re about to find out if inflation is one of them.