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.

Mr. Greenspan's "Prediction" and The Media

In an interview Alan Greenspan gave on one of the Sunday morning TV shows, he made the comment that he "suspects" that the unemployment rate will rise above 10% and stay there for a while before it subsequently starts coming down.


This was actually a comment devoid of any insightful content. Mr. Greenspan simply stated something that is widely acknowledged as an extremely high probability outcome (bordering on self-evident) at this point, that is, that the unemployment rate- already at 9.8%- is poised to cross the 10% mark in the foreseeable future.

The unemployment rate is a lagging indicator and the past pattern of its behavior shows a strong tendency of it peaking, by a varying lag, after the end of a recession. The reason for that is that with the first signs of improvement that emerge toward the beginning of an economic recovery, previously discouraged workers that had dropped out of the labor force are coming back, therefore swelling the size of the labor force faster than the pace at which the economy can absorb them.

For example, in the 2001 recession, the rate did not peak until 19 months after its official end, while in the 1990-91 recession, it peaked 15 months after it ended. The 1981-82 recession was somewhat of an exception, as there was a synchronized peak of the unemployment rate with the trough of the business cycle in November 1982. In the highly peculiar recession of 1980, the peak in the rate also coincided with the low point of that unusual cycle. The 1973-75 recession led to a peak in the unemployment rate just a couple of months after its end.

The reason for which, in some cases, the rate has peaked almost simultaneously with the trough in economic activity is that the economy came roaring back at very robust rates of GDP growth (5%, 6% or higher, in the first year of the recovery), allowing it to absorb fully the workers re-entering the labor force. It has already been established that, given the array of headwinds at work, this recovery is not likely to be of sufficient vigor to generate enough jobs early on to prevent the rate from rising.

Mr. Greenspan certainly understands all of that extremely well, as he has always been a diligent student of economic history. In fairness to him, he most likely, did not even think he was making a particularly novel prediction by saying that the unemployment rate will rise above 10%. (True, he used a particularly cautious tone "My own suspicion is that we're going to penetrate the 10% barrier and stay there for a while...", but this can be chalked up to his many years of having perfected a unique brand of impressively careful and convoluted statements, which he evidently has a hard time shedding now).

The somewhat amusing thing is not as much that Mr. Greenspan offered that bland observation about the direction of the unemployment rate, but that his comment has received quite a bit of play in the media in the last 24 hours, financial and otherwise, with headlines of the kind "Alan Greenspan predicts that the unemployment rate will rise to 10%" etc. One simply has to assume that, given the transparent banality of Mr. Greenspan's so-called "forecast", the media either did not recognize that as such or it has been a particularly slow news cycle this weekend that sent them to a desperate search for a "headline".

Anthony Karydakis