Two Characteristics of U.S. Inflation Spikes When Caused by Supply Bottlenecks

November 15, 2021

The former economics Nobel prize-winner and current New York Times OP-Ed columnist Paul Krugman wrote a piece last week asserting that elevated inflation this year more closely resembles patterns in 1947 than in 1979. It’s an interesting take, original at first glance yet obvious when one reflects on the the root cause of what’s driving prices higher.

The inflation that led the Federal Reserve to reframe how to secure its mandate to preserve price stability in 1979 had a very long fuse that initially was lit a decade and a half earlier as American demand was goosed by a build-up of government spending on the Vietnam War and Great Society programs and was accommodated chronically by a Federal Reserve that was reactive, not proactive, in facing down that danger. When key global commodity shortages occurred in the 1970s, aggregate demand was already overheating. A quantitative approach to Fed policy announced in October 1979 came six years after the first OPEC shock and months after the Iranian Revolution that fed a second oil price moonshot. The long run-up to this year’s inflation was an extended period of weaker-than-normal economic growth stretching back two decades and including the two steepest U.S. economic contractions since the Second World War.

The central feature of this year’s upsurge in prices has been many and broad product delays after the self-induced stoppage of productive activities to contain a global pandemic. The public health crisis exposed the dark side of a world economy that had become too interwoven for its own good. This isn’t quite the same predicament that impacted the U.S. economy after the Second World War but the result so far as prices are concerned has been very analogous. The problem then was retooling U.S. industry to produce consumer goods following a wartime footing when factories were directed to meet military needs and domestic demand was suppressed by rationing.

I took a look more closely at the behavior of the U.S. CPI index after WWII with two questions particularly in mind: how high did inflation then get, and how long did it take for the spike to recede to a low and sustainably stable pace? Consumer prices had risen just 1.6% in 1944 and 2.3% in 1945. In 1946, inflation accelerated progressively, averaging 8.5% for the year and reaching all the way up to 19.7% by March 1947. That’s five percentage points above the peak reached early in 1980. Without coaxing from monetary policy, the 12-month increase in the CPI receded to 8.8% by December 1947 and 3.0% by December 1948 but not before posting back-to-back calendar year average rises of 8.5% in 1947 and 7.7% in 1948.

The supply-side inflation in the immediate post-WWII years was complicated by the Korean War, which created a whole fresh array of bottlenecks. But that problem gets ahead of our timetable. First, inflation spent much of 1949 in sub-zero territory, with a low of -2.9% in August and matched in a few other months that year. The 1949 CPI average rate was -1.0%, and it remained below zero percent in the first half of 1950, averaging just 1.1% for that year as a whole. By the end of 1950, however, CPI inflation had climbed back to a disturbing 5.9%, that is similar to the 6.2% announced last week. By February 1952, CPI inflation was all the way up to 9.4%, and the average pace in 1951, at 7.9%, even exceeded that of 1948.

Supply-side stress had dissipated mostly by early 1952, and consumer prices on average only rose 2.3% that year and was down to a dangerously low 0.8% by the year’s final month. Even more striking, no longer-term inflationary fallout ensued from the supply-side shocks that arose in 1946 and lingered on and off for six years. Over the ten years between 1952 and 1962, consumer price inflation in the United States only averaged 1.3% per annum.

The lessons that strike me from this examination are, first, that major supply-side price shocks pack a huge punch and, second, that predictions shared by governments and private forecasters initially that the elevation of inflation would last just a few months and blow over fairly quickly were unrealistic. One also might infer that monetary policy is not a particularly suitable tool for preventing a spike in inflation induced by a major interruption of the natural flow of factors needed for production. A couple of 25 basis point interest rate hikes done early isn’t going to make much of a difference in the trajectory of inflation. Alternatively, attacking inflation with everything we’ve got — say a combination of a big cumulative rise of the federal funds target in 9-12 months plus scrapping the build back better fiscal initiative — might get the job done but at the risk of inducing a serious recession in the next year or two — and for what? The 1946-51 experience suggests that inflation caused by supply delays are best handled by fostering a quick repair of that cause, and longer-term inflation expectations will stay anchored.

Copyright 2021, Larry Greenberg. All rights reserved. No secondary distribution without express permission.



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