How Quickly Might an Inflation Problem Surface in the United States?

May 13, 2014

Under the stewardship of Fed Chairwoman Yellen, the debate about appropriate Fed policy has honed in on labor market analysis even more than had been the case under her predecessor.  Both Ben Bernanke and Janet Yellen came into their Fed leadership roles with a background as trained economists.  Bernanke’s professional expertise, the Great Depression and Fed policy in back in that day, made him ideally suited for the crisis that he faced.  Similarly, Yellen’s area of expertise, the labor market, will serve her well in deciding a timetable for transitioning from an ultra-accommodative policy designed during Bernanke’s crisis to a sufficiently less stimulative stance that will lift inflation back to target but not far above such.  It’s a difficult assignment given the fact that changes in monetary policy affect real economic activity and ultimately inflation only after a long and variable lags.

The debate between Yellen’s supporters and critics now centers around the best labor market measures to gauge future wage pressures. Depending on what data one chooses, it’s now possible to conclude, as the Fed does, that wage inflation is nowhere in sight, or to maintain that portents of cost-push pressure are now appearing sporadically and bear watching.  This kind of academic/technocratic argument can go around and around endlessly in circles, settling nothing and merely fortifying the Fed’s critics and supporters in their belief but converting nobody to the other side. 

I submit a different line of study for gauging how much lead time the Fed safely has to shift gears, and this recommendation rests heavily on how long it took for inflation to take root before the extreme problems that mushroomed during the 1970s.  The U.S. inflationary Rubicon was in fact crossed during 1966.  The December-over-December rise in consumer prices had been 1.4% in 1960, 0.7% in 1961, 1.3% in 1962, 1.6% in 1963, 1.0% in 1964, and 1.9% in 1965.  The results vary from year to year as one would expect but there is no cumulating break-away in trend either up or down.  The series over the balance of the 1960s decade then accelerates to 3.5% in 1966, 3.0% in 1967, 4.7% in 1968, and 6.2% in 1969. 

The current period is different from 1966 in three dramatic and related respects. 

  • Most importantly, 1966 was preceded by a decade of rapidly advancing aggregate demand.  Real GDP grew 4.0% per annum between 4Q55 and 4Q65 but only 1.6% per year between 1Q04 and 1Q14.  Resource under-utilization — so prominent now — did not exist when the Fed mistakenly held to an excessively loose stance for too long in the 1970s
  • Fiscal policy sustained excessive real growth even after inflation started to accelerate in 1966.  The U.S. federal government did not make the hard selection of guns or butter but not both, choosing instead the military buildup in Vietnam and the Great Society domestic programs at home.  In contrast, total U.S. real government expenditures during a period of historically high unemployment contracted 3.2% in 2011, 1.0% in 2012 and 2.2% in 2013. 
  • Inflation generally originates after a period demand growth outstripping the expansion of supply.  In time, this demand-pull strain on price levels is often augmented by cost-push pressure from wage demands that incorporate expected higher inflation and rising commodities.  Organized labor is nowhere near as powerful in 2014 as it was a half-century ago.

A lesson of the 1970s inflation is that it takes years of the right conditions to nurture a condition of excessive inflation, and the good news is that one gets plenty of advanced warning before an inflationary threshold-of-difficult-return is crossed.  Yellen’s professional credentials to determine when to tighten are much more impressive-looking than her critics.  And while examples abound when the best-and-the-brightest advisors led populations into poor decisions, history in this case also seems to support those like Yellen who consider the risk of too little inflation to be greater than the risks of too much inflation.

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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