The great inflation: inflation, inflationary expectations, and the Phillips cycle 1960-2002: improvements in monetary policy tamed inflation once—can they do it again?

Business Economics, April, 2008 by Thomas W. Synnott, III

Given the ongoing concern with controlling inflation, it is timely to take another look at the "Great Inflation" of 1966-1983 and to try to understand the process that led to ever-higher peaks of inflation and interest rates. How was this apparently intractable dynamic reversed? While a member of the Board of Governors, Federal Reserve Chairman Ben Bernanke set forth three explanations for the decline in macroeconomic volatility: structural change, improved macroeconomic policies, and good luck. While luck is not controlled by government, and government has only tangential influence on structural change, macroeconomic policy is solely the responsibility of the federal government, particularly the Federal Reserve System. Improvements of monetary policy were largely responsible for taming the Great Inflation, but new threats--including the dimming of memory--are current challenges to preventing its recurrence.

The rise and fall of inflation from 1960-2002 included the "Great Inflation" of 1966-1983 (1) and had enormous consequences for financial markets and the real economy, not only in the United States but in many of the world's other economies as well. An important factor in the Latin American debt crisis of 1982, for example, was the period of ultra-high U.S. short-term interest rates accompanying the Federal Reserve System's anti-inflationary monetary policy.

Given the ongoing concern with controlling inflation, it is timely to take another look at the Great Inflation and to try to understand the process that: led to ever-higher peaks of inflation and interest rates. Indeed, the seemingly intractable nature of that process caused prominent economists to despair of ever "getting inflation under control" with traditional monetary and fiscal policy tools. As Paul Samuelson put it in the 1980 edition of his famous textbook:

  Keeping unemployment in a mixed economy down below some critical
  region does result in a tendency for the rate of creeping inflation
  to become a canter or even a gallop. To avoid accelerating inflation,
  one must find new tools of incomes policy to shift Phillips-curve
  tradeoffs, short-run and long-run, and not merely turn off and on the
  faucets of fiscal and monetary policy to move the system along
  unchanged Phillips curves that look temporarily appealing (p.779).

The tone of this paragraph contrasts sharply with his optimism about achieving a reasonable balance between growth and price stability expressed in the Fifth Edition, published in 1961. There, he prescribed a "paired program of easy monetary and tight fiscal policy" to raise the share of investment in GDP and hence the long-term growth rate of the economy. He concluded that, though growth presents problems, it is essentially a cheerful subject" (p.816).

A great deal happened in the intervening years, of course, to change his and other economists'views of the relationship between inflation and growth. Looking back on this period of the rise and fall of inflation, one is left with several unsettled questions:

* How did inflation develop such an apparently unstoppable momentum?

* Is there a trade-off between inflation and unemployment--as was taught in the 1960s, based on Phillips Curve evidence?

* What is the role of inflationary expectations?

* What explains the "Great Moderation" in the fluctuations of the real economy and inflation over the last 20 years or so?

* What are the implications for monetary policy today?

My passionate interest in inflation stems partly from personal experience. I remember very clearly when I heard the term "inflationary expectations" for the first time. It was in the spring of 1968 when Dr. James O'Leary, a long-time student of the financial markets, explained its importance to a group of dumbfounded senior officers at the United States Trust Company of New York. As primarily managers of common stock investments, we had all paid relatively little attention to fluctuations in inflation and interest rates. That attitude changed dramatically in the next ten years. Today, "inflationary expectations" are measured and discussed continuously by Federal Reserve officials, by participants in financial markets, and on the financial talk shows.

1. A Brief History of the Great Inflation

Inflation, inflationary expectations, and long-term interest rates are inseparably related. Through the first half of the 1960s, all three were low and stable, as Figure 1 shows. In a book published under the auspices of the Graduate School of Banking at the University of Wisconsin in 1968, featuring essays by Sidney Homer and other students of U.S. financial markets, Homer wrote that "It seems possible that we will learn something from the mistakes of 1965-67 and not repeat them again, at least not more than once again." At that time, he and the other authors put more emphasis on ending the war in Vietnam and reducing the Federal deficit than on monetary policy. Unfortunately, fiscal restraint did not prevent further surges in inflation that culminated in 1980, reaching nearly 14 percent in the CPI. A year later, the yield on ten-year U.S. Treasury bonds averaged 14 percent also.