Another Look at Inflation

January 11, 2023

Paul Krugman’s New York Times column this past Tuesday reprimands economy deniers spreading the fallacies that the U.S. economy is in recession and inflation is still rising. Gross domestic product and employment are both increasing at a respectable pace, and consumer price inflation fell to 7.1% in November after cresting at 9.1% in June.

History nonetheless supports Fed officials, who haven’t declared victory over inflation, warn of more rate hikes in the near term and maintain that it will probably be a long time before federal funds target can be lowered. A big lesson of the elevated inflation experienced a half century ago is that big retreats in year-on-year price changes did not signal the end of the problem. That wasn’t so in 1971, 1976, or 1983. An erosion of price stability that began in the mid-1960’s didn’t truly disappear until just over three decades later.

Let’s review. U.S. CPI inflation had averaged 1.3% per year over the eight years through January 1966 but heated up in the second half of the 1960’s, fed by commodity supply shocks, the Vietnam War, and other factors feeding rapid demand growth. The first wave of the CPI inflation upswing peaked at 6.6% in the final two months of 1971. Inflation fell back to 2.7% by mid-1972 but climbed to an even higher peak of 12.3% at the end of 1974. That second wave saw inflation of at least 10.0% from February 1974 through April 1975.  As with the first wave, a recession tamed inflation this time but again only temporarily. The third and most virulent wave began from a base of 4.9% in January 1976. The ensuing peak of 14.8% was seen in March 1980, and double-digit price changes occurred from March 1979 through October 1981. Even after inflation had retreated back to 2.5% in July 1983, almost a decade and a half would elapse before the current Fed mission of sustainable inflation around 2.0% had been delivered. In the year to October-November 1990, for example, consumer price inflation ran at 6.3%, and it averaged 3.4% per year over the fourteen years ending July 1997.

But even that drawn-out fight was hardly a picture of catastrophe, considering that U.S. real GDP expanded at a 3.7% pace between the onset of price instability after 1965 and mid-1997. By 21st century standards that’s amazingly strong economic growth. There are sobering lessons to be learned. Number one, there’s much still to be learned about the dynamics of inflation, and forecasting such with any consistent accuracy — whether over the next six months, two years, or longer stretches of time — is so incredibly elusive.

Number two, there is a crucial difference rarely mentioned that distinguishes the 2021-22 episode from the one documented above. The dollar was chronically under selling pressure in the late-1960’s and 1970’s but has been well bid this time. Dollar exchange rates measure the external value of U.S. money, and U.S. inflation measure changes in its internal value. The two ought to move in tandem. The fact that they haven’t done so in the recent episode suggests that the spike of inflation this year has far less origin in U.S. developments than was the case many years ago, and that leads to inference number three.

In the 20th century the Fed was in the cross-hairs of people wanting someone to blame for high inflation, but years of economic globalization and neglected problems like climate change that affect everyone and to varying degrees stem from negligence and policy dictated by short-term considerations everywhere suggest that the effect of any central bank on inflation is much less direct and complete now than then. That goes for even the Federal Reserve.

Inflation has already moved down in the United States and many other countries, but now is far too early to close the chapter on the price spike that began in 2021. Fed officials are right to treat questions with extreme caution on central banking matters such as how high interest rates need to go or when it might be safe to tilt the direction of policy back toward ease.

Copyright 2022, Larry Greenberg. All rights reserved. No secondary distribution without express permission.



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