Monday, October 5, 2009

The 1970s Inflation Experience: An Unlikely Comeback

By Scott Tolep

There is considerable concern in some quarters that, over the medium-term, the US faces a sharp rise in inflation similar to the 1970s.

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This view is based primarily on the fact that the Fed will be unable to remove the massive amount of liquidity from the system before higher inflation becomes entrenched in the economy and inflation expectations adjust upward. This process will undoubtedly require precise technical judgment on the part of the Fed, given the lag between the increase in the money supply and its effects on the economy and the overall price level. However, to suggest that the US will experience 1970s-like inflation may be overlooking the following key distinctions between now and then:

1) The experience in the late 1970s was preceded by nearly a decade of rising inflation stemming from the Fed’s willingness to trade higher inflation for less unemployment. By the time the Fed was given a mandate (in 1979) to control inflation at all costs, the public’s inflation expectations were firmly anchored at a very high level. This led to the vicious cycle of monetary restraint and ease where rates fluctuated within a range of 1,000 basis points between March-1980 and July-1981. In contrast, inflation over the past decade has been in the 2-3% range, longer-term inflation expectations are currently stable, and the Fed’s mandate to maintain price stability is now a well-established policy that has been around for 30 years.

2) The unprecedented shock in oil prices between 1973 and 1980 reinforced the already well-anchored, high inflation expectations. This adversely impacted the Fed’s ability to use monetary policy as a tool in resetting inflation expectations. No one knows exactly where oil prices are headed, but it seems reasonable to assume that when the Fed starts raising rates, it will not follow a 7-year period in which oil prices had increased by 500%.

3) The fundamental outlook on unemployment is different now than it was in the 1970s. Compared to the 1973-1975 recession, there is now a much higher probability for a “jobless recovery”. Capacity utilization rates today are lower, the banking sector is in appreciably worse condition, and households are more likely to save and de-leverage. There seems to be a growing acceptance that going forward, the baseline level of structural unemployment in the US may be in excess of the 5-6% range it has been accustomed to over the past 15 years. After the 1973-1975 recession, unemployment was gradually reduced to pre-recessionary levels. A drive by monetary policy to achieve a similar objective this time around does not appear to be a realistic prospect, which should alleviate some of the political opposition the Fed may face in its decision to withdraw liquidity from the system.

Once the economic recovery is well underway, it is reasonable to assume that inflation will, at least initially, drift above the 2-3% implied target. But predicting a return to the days of 10%+ inflation does not take into account some fundamental differences in the economy and the role of the Fed today as compared to the 1970s.

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