Many people, especially Federal Reserve people, tell all of us not to be concerned about inflation. The history of the 1960s and 1970s makes me skeptical.
During the 1970s, members of the Fed’s open market committee promised themselves and each other that they would persist in their several efforts to slow or stop inflation. When the unemployment rate rose to about 6.5 or 7%, those commitments vanished. Policy instead aimed at reducing unemployment. That happened three or four times as recorded in the transcripts or minutes of their meetings.
One consequence was a growing belief that the Fed would not persist in an anti-inflation policy. Markets quickly lowered inflation in 1966-67, but they didn’t do much in the 1969-70 recession or after. They learned that the Fed responded decisively to the unemployment rate but not to the inflation rate. The Fed and many others called this behavior “stagflation” and expressed puzzlement that recessions could coexist with inflation. They failed to recognize expectations that inflation would continue.
Contrary to the Phillips curve that predicts a negative relation between inflation and unemployment, the relation is broadly positive in the 1970s and 1980s. The Fed staff under-predicted the rise in inflation.
From 1979-82 the Fed changed policy. The main effort changed from preventing unemployment to controlling inflation. The unemployment rate rose to more than 10% in the fall of 1982, but inflation was down to 4% and later declined more.
Why did the policy change? Three reasons. First, opinion polls showed that the public thought inflation was the main economic problem. That had not happened earlier. It changed the political consensus toward inflation control. Second, President Carter did not interfere with the Fed during the election of 1980. President Reagan supported the anti-inflation policy. Chairs of the key congressional committees also supported the anti-inflation policy and supported Paul Volcker, the Fed chairman and a committed anti-inflationist who had the courage and determination to carry the policy through.
I do not doubt that the current Fed has the technical ability to end inflation. I do not see the political consensus by the administration, Congress, business, labor, and the public to support an anti-inflation policy with unemployment currently 9.4 % and rising. It takes about two years from the start of the anti-inflation policy until inflation begins to fall. Part of the lag is the time it takes to convince markets that the policy will continue after unemployment rises.
Can the Fed control inflation? Absolutely. Will the Fed control inflation? Unlikely. The Fed will face political pressures. It has sacrificed much of its independence and will have a hard time getting it back.
In 1980, I had the privilege of advising Prime Minister Margaret Thatcher to ignore the demands of 360 British economists who made the outrageous claim that Britain would never (yes, never) recover from her decision to reduce government spending during a severe recession. They wanted more spending. She responded with a speech promising to stay with her tight budget. She kept a sustained focus on long-term problems. Expectations about the economy’s future improved, and the recovery soon began.