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The costs of the Great Inflation: More frequent and deeper recessions

Inflation is at a 40-year high—as measured by either the consumer price index or the personal consumption expenditures price index.

Federal Reserve officials have long believed that controlling inflation is a necessary condition for achieving the Congressional mandates of price stability and maximum employment. Implicit in this belief is the view that high inflation—particularly if it’s unexpected—imposes a broad array of economic costs on the economy.

For example, parts of the U.S. tax code are not annually adjusted for inflation. Inflation is a tax on cash balances. And high inflation can worsen uncertainty about future interest rates, which tends to raise financial market volatility and lower prices for financial assets such as stocks and bonds. In short, high inflation reduces the efficient allocation of resources in a market economy.

The Great Inflation, from the late 1960s to the early 1980s, was a prime example of the corrosive effects of high inflation. U.S. inflation rose sharply, as did the unemployment rate; but it also became much more volatile. High and volatile inflation meant the FOMC was never sure in real time if a decline in inflation was temporary or longer lasting. These distorted inflation signals contributed to the “stop-go” policy of the 1970s, including the tendency to ease policy when inflation fell. But inflation did not return to its previous rate. It rebounded rapidly and eventually rose to more than 14% in 1980. This turbulence increased the volatility of real GDP growth as well.

The FRED graph above shows four recessions in about a dozen years—roughly every three years beginning with the 1970-71 recession and ending with the 1981-82 recession. Until the 2007-09 recession, the 1973-75 and 1981-82 recessions had been the deepest in the post-WWII period. Also, there was a sharp slowing in labor productivity growth around 1973 that lasted for 20 years, until the microchip-led productivity boom commenced around 1994.

There were many factors that led to the Great Inflation—both bad luck and bad policies:

  • oil and commodity price shocks that reduced aggregate supply
  • rising transfer payments that helped boost aggregate demand
  • the imposition (and subsequent loosening) of price controls imposed after the Camp David meeting in 1971

However, as former Federal Reserve Chairman Paul Volcker demonstrated early in his tenure, one key ingredient that was lacking during the Great Inflation was a commitment to restore price stability.

How this graph was created: Search for and select the CPI series in FRED. Restrict the sample period to 1966-01-01 to 1982-12-10 with the date picker above the graph, the slider below the graph, or your mouse (by highlighting the period you want in the graph itself. From the “Edit Graph” panel, change the units to “Percentage change from year ago.”

Suggested by Kevin Kliesen.

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