FRBSF Economic Letter
2000-21; July 7, 2000
 Economic
Letter Index
Exploring the Causes of the Great Inflation
Over the past year, the Federal Reserve has been raising short-term interest
rates. These rate hikes are designed to prevent inflation from trending
upward from the low levels enjoyed by U.S. consumers over the past several
years. In light of these actions, it is perhaps worthwhile to reflect
on an earlier period of U.S. history when inflation performance was not
so good. In this Economic Letter, I review some theories that try
to account for the rise of U.S. inflation during the 1960s and 1970s (often
referred to as the "Great Inflation") and the abrupt disinflation
in the early 1980s.
A satisfactory theory of the historical pattern should address the following
questions:
- Why did events happen when they did? In other words, what was different
about the period from 1965 to 1980 that allowed CPI inflation to go
from less than 2% to over 12%? Why did the disinflation occur in the
early 1980s and not some other period?
- Why do we see a similar historical pattern for inflation in Canada
and many European and Pacific Basin countries? What was different about
Japan where the disinflation occurred earlier--in the mid-1970s--as
opposed to the early 1980s in the other countries?
- Can these events happen again?
Theories about the Great Inflation fall roughly into one of three categories:
bad luck theories (which emphasize chance events outside the Fed's control),
policy mistake theories (which emphasize discretionary actions by Fed
policymakers), or combination theories (where chance and discretion both
play a role).
Bad luck theories
In work by Orphanides (1999), which is further explored in Lansing (2000),
the hypothesis is that Fed policymakers of the 1970s did not know that
trend productivity growth, and hence the economy's sustainable growth
rate, slowed dramatically around 1973 for some reason that has yet to
be fully understood. One version of the story goes like this: to construct
an estimate of the economy's sustainable growth rate, Fed policymakers
fit a trend through the historical data. When incoming data started falling
below the fitted trend because of the abrupt productivity slowdown, policymakers
interpreted the data as evidence of a severe recession. In an effort to
"lean against the wind," policymakers lowered short-term interest
rates. Though well-intentioned, this policy turned out to be overly expansionary
because it did not account for the reduction in the economy's sustainable
growth rate. The result was higher inflation. As more data came in over
time, policymakers adjusted the fitted trend, improving their estimate
of the economy's sustainable growth rate. However, with interest rates
still below previous levels, inflation continued to rise. Eventually,
inflation rose to a point where Fed policymakers were motivated to reverse
course and start raising interest rates to fight inflation. The momentum
in inflation was such that the Fed could not turn things around until
the early 1980s.
A problem with this story is the timing of the rise in inflation. The
theory ties the rise to the productivity slowdown, but research places
the slowdown sometime in the early 1970s, not the mid-1960s, when U.S.
inflation actually began to rise. The theory does provide a rationale
for the timing of the disinflation, however, as the combination of the
Fed's sluggish learning of the slowdown and the inherent momentum in inflation
could explain why it took until 1980 before inflation peaked and started
heading back down. The theory also may help explain the similar inflation
patterns of other countries because many developed economies experienced
productivity slowdowns around the same time. Finally, the theory suggests
that the above events, or their mirror image, can happen again. Since
1995, for example, the U.S. economy has experienced a surge in capital
investment linked to computers and information technology. Productivity
growth has picked up while inflation has declined. These observations
have led some economists and policymakers to conclude that another shift
in the economy's sustainable growth rate has occurred, this time in the
positive direction. This is the celebrated "new economy" view.
Under this interpretation of the theory, incoming real GDP data consistently
plots above a fitted trend extrapolated from past data. Policymakers interpret
the data as evidence of a boom and raise short-term interest rates to
restrain aggregate demand. This, in turn, contributes to lower inflation.
In reality, of course, there remains a great deal of uncertainty about
whether the U.S. economy's sustainable growth rate has actually increased.
The chance event of the productivity slowdown also plays a crucial role
in work by Braun (1984). In Braun's model, workers base their real wage
demands on productivity growth extrapolated from the past, while firms
base their real wage offers on the economy's true underlying growth rate
of productivity. Braun argues that the productivity slowdown of the early
1970s caused workers to bargain for and obtain real wage increases in
excess of their true productivity gains. Firms passed along the additional
wage costs to consumers in the form of higher prices, thereby setting
off a wage-push inflation spiral. In addition to problems explaining the
rise of U.S. inflation in the mid-1960s (before the onset of the productivity
slowdown), this theory does not explain why workers and firms have different
information about the true growth rate of productivity.
Blinder (1982) develops a theory that relies mostly on bad luck. He argues
that oil and food price shocks, coupled with pent-up inflation from the
release of the Nixon wage-price controls in 1974, can account for most
of the rise in inflation during the 1970s. He also argues that the absence
of these same factors can account for most of the fall in inflation during
the early 1980s. Fed policymakers share part of the blame because they
attempted to offset the contractionary effects of the oil shocks with
expansionary monetary policy. DeLong (1997) points out two problems with
Blinder's story. First, inflation started rising in the mid-1960s before
the first oil shock took place. Second, there is no evidence that the
temporary bursts of price inflation from the oil shocks affected the time
path of wage inflation--a prerequisite if we are to believe that the oil
shocks determined the course of the long-run inflation trend. Taylor (1997)
points out that the second oil shock in 1979-1980 did not produce a strong
burst of inflation in Japan, lending support to the view that monetary
policy, not the oil shocks, was the driving force behind inflation.
Policy mistake theories
Hetzel (1998) and Mayer (1999) take the approach of investigating the
views held by Federal Reserve officials during the 1960s and 1970s. Both
authors contend that policymakers believed incorrectly that much of the
observed inflation was determined by factors outside of the Fed's control.
They also argue that the imposition of wage-price controls in 1971 opened
the door to the pursuit of an overly expansionary monetary policy because
Fed policymakers believed that the controls would do the job of restraining
inflation. These ideas do not explain why inflation started rising in
the mid-1960s and leave open the question of what caused Fed policymakers
to change their views about inflation.
Other theories emphasize policymakers' mistaken belief in an exploitable
Phillips curve trade-off, i.e., the notion that monetary policy could
permanently lower unemployment by generating higher inflation. DeLong
(1997) argues that this belief, coupled with a strong aversion to unemployment
engendered by the memory of the Great Depression, led policymakers to
pursue an ill-fated attempt to drive the unemployment rate below 4% and
keep it there. After experiencing the unpleasant effects of high inflation,
policymakers reversed course and brought inflation back down.
Taylor (1997) argues that DeLong's theory does not explain why policymakers
waited until the mid-1960s to abandon price stability, as opposed to an
earlier period closer to the Great Depression. He further argues that
tracing the history of the Phillips curve helps account for both the rise
and fall of U.S. inflation. The intellectual development of an exploitable
Phillips curve trade-off in the 1960s and its subsequent adoption by policymakers
explains why inflation started rising when it did. Some years later, economists
Edmund Phelps and Milton Friedman argued persuasively that any such trade-off
was bound to be short-lived: once people came to expect the higher inflation,
monetary policy could not keep unemployment below its long-run equilibrium,
or "natural," rate. Their claim was later borne out by the experience
of the 1970s when rising U.S. inflation did not bring about the lower
unemployment rates promised by the Phillips curve. On the contrary, higher
inflation coincided with higher unemployment--a combination that became
known as "stagflation." The experience of the 1970s caused policymakers
to abandon the notion of an exploitable Phillips curve trade-off. This,
together with changing views about the economic costs of reducing inflation,
led policymakers to pursue a disinflationary policy by 1980. Taylor's
theory can be applied to other countries as well. Pagan, Gruen, and Thompson
(1999) trace the intellectual development of the Phillips curve within
the Reserve Bank of Australia and discuss its possible influence on monetary
policy.
Combination theories
Sargent (1999) develops a theory that includes some elements from DeLong
(1997) and Taylor (1997), and builds on the well-known Kydland-Prescott
(1977) model of inflation. In the Kydland-Prescott model, discretionary
policymakers are tempted to create surprise inflation in order to temporarily
push unemployment below the natural rate. Private sector agents recognize
this temptation and adjust their inflation expectations upward accordingly.
In equilibrium, no surprises occur but the economy ends up with higher
than optimal inflation.
In Sargent's version, discretionary policymakers choose an inflation
rate based on their mistaken belief in an exploitable Phillips curve trade-off.
The menu of perceived choices between inflation and unemployment is constructed
by fitting a Phillips curve to historical data. Random shocks to the economy
may alter the perceived trade-off between the two variables, thereby leading
to a small reduction in the inflation rate. This generates new data that
alters the perceived trade-off in the next period, and so on. The feedback
process eventually causes policymakers to discard their belief in an exploitable
trade-off. In such an environment, the optimal policy is clear: reduce
inflation. These events happened in the early 1980s by chance, but the
initial conditions for the model simulations can be tied to the intellectual
development of an exploitable Phillips curve trade-off in the 1960s. Sargent's
theory implies that the reduction in inflation is unlikely to be permanent,
however. Even when inflation is low, policymakers continue to update their
estimates of the Phillips curve. Eventually, incoming data suggests that
it may be possible to exploit a Phillips curve trade-off once again. Private-sector
agents adjust their inflation expectations upward accordingly. In this
way, inflation can work its way back into the economy.
Parkin (1993) develops a theory that builds on a key feature of the Kydland-Prescott
model, namely, that an increase in the natural rate of unemployment leads
to an increase in the equilibrium inflation rate, and vice versa. This
occurs because changes in the natural rate influence policymakers' temptation
to engage in surprise inflation behavior. Parkin argues that the Kydland-Prescott
model predicts rising inflation during the 1960s and 1970s and declining
inflation during the 1980s because demographic shifts have created a similar
hump-shaped pattern in the natural rate of unemployment. During the 1960s
and 1970s, the peak of the baby boom generation was passing through a
period of high life-cycle unemployment: the teen years and early twenties.
During the 1980s these same individuals took on more stable jobs as they
became older. Parkin's theory has the potential to explain inflation behavior
in other countries because population aging patterns in industrialized
nations appear to be synchronized. There are several problems however.
First, U.S. inflation peaks around 1980 and starts to decline several
years before we observe a decline in the U.S. unemployment rate.
The theory says that these movements should coincide. Second, as Parkin
admits, the Canadian unemployment rate continued to increase throughout
the 1980s while Canadian inflation was coming down dramatically. Third,
as Taylor (1997) points out, European unemployment also kept rising during
the 1980s while inflation was falling.
Conclusion
Understanding the causes of the Great Inflation is important because
it can shed light on various aspects of the economy's behavior that may
help improve the conduct of monetary policy in the future. The theories
described above focus on a single explanation for the historical episode
because researchers wish to isolate the merits and drawbacks of a particular
story. Nevertheless, researchers recognize that elements from many different
theories could have been (and probably were) operating simultaneously
within the U.S. economy.
Kevin J. Lansing
Senior Economist
References
Blinder, Alan S. 1982. "The Anatomy of Double-Digit Inflation in
the 1970s." In Inflation: Causes and Effects, ed. R. Hall,
pp. 261-282. Chicago: Univ. of Chicago Press.
Braun, Steven. 1984. "Productivity and the NIIRU (and Other Phillips
Curve Issues)." Board of Governors of the Federal Reserve System,
Working Paper 34.
DeLong, J. Bradford. 1997. "America's Peacetime Inflation: The 1970s."
In Reducing Inflation: Motivation and Strategy, eds. C. Romer and
D. Romer, pp. 247-276. Chicago: Univ. of Chicago Press.
Gruen, David, Adrian Pagan, and Christopher Thompson. 1999. "The
Phillips Curve in Australia." Journal of Monetary Economics
44, pp. 223-258.
Hetzel, Robert L. 1998. "Arthur Burns and Inflation." FRB Richmond
Economic
Quarterly, pp. 21-44. <http://www.rich.frb.org/eq/pdfs/winter1998/hetzel.pdf>
accessed June 2000.
Kydland, Finn E., and Edward C. Prescott. 1977. "Rules Rather than
Discretion: The Inconsistency of Optimal Plans." Journal of Political
Economy 85, pp. 473-491.
Lansing, Kevin J. 2000. "Learning
about a Shift in Trend Output: Implications for Monetary Policy and Inflation."
Unpublished manuscript. FRB San Francisco. <http://www.sf.frb.org/econrsrch/workingp/2000/wpkl00-04.pdf>.
Mayer, Thomas. 1999. Monetary Policy and the Great Inflation in the
United States. Cheltenham, UK: Edward Elgar.
Orphanides, Athanasios. 1999. "The Quest for Prosperity without
Inflation." Unpublished manuscript. Federal Reserve Board, Division
of Monetary Affairs.
Parkin, Michael. 1993. "Inflation in North America." In Price
Stabilization in the 1990s, ed. K. Shigehara, pp. 47-83. London: Macmillan.
Sargent, Thomas J. 1999. The Conquest of American Inflation. Princeton:
Princeton Univ. Press.
Taylor, John B. 1997. Comment on "America's Peacetime Inflation:
The 1970s." In Reducing Inflation: Motivation and Strategy, eds.
C. Romer and D. Romer, pp. 276-280. Chicago: Univ. of Chicago Press.
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