The Great Inflation of the 1970s

The Great Inflation refers to the period from 1965 to 1982 characterized by exceptionally high rates of inflation in the United States and throughout much of the developed world. This prolonged era of stagflation, a combination of high inflation and slow economic growth, wreaked havoc on economic productivity and presented complex challenges for policymakers.

Origins of the Crisis

Economists debate the precise causal factors behind the Great Inflation’s inception, but several likely catalyzed the problem:

• Overstimulation from increased government spending on the Vietnam War and Great Society social programs.
• Accommodative Federal Reserve policy keeping interest rates low, which encouraged borrowing and spending.
• Supply shocks from the 1973–74 and 1979 oil crises, which caused energy prices to soar, and food price spikes due to poor harvests
• Decline in US productivity growth after fast gains in prior decades, which made it harder for businesses to absorb rising costs.
• These drivers created a damaging feedback loop of rising consumer prices, slowing economic output, and entrenched inflation expectations that policymakers struggled to unwind. The Consumer Price Index (CPI), a key measure of inflation, rose from an annual rate of 1.6% in 1965 to over 14% in 1980.

Key Effects on the Economy

The Great Inflation took a heavy toll before its ultimate unwinding by the early 1980s:

• Interest rates surged from around 6% in 1965 to an apex of 20% by 1981 as the Federal Reserve tried to restrain price growth.
• Two major recessions struck in the mid and late 1970s amid the Fed’s tightening, with GDP growth falling to -0.2% in 1974 and -0.3% in 1980.
• Corporate profits declined significantly from higher wages and input costs, with the S&P 500’s earnings per share falling over 20% from 1973 to 1975.
• Stock markets treaded water for years as valuation ratios contracted, with the S&P 500 index posting a meager 6.6% total return from 1965 to 1982

The misery index, which adds unemployment and inflation rates as an economic stress indicator, peaked at over 20% in the era’s final years, underscoring the pain felt by many Americans.

Ending the Crisis

Ultimately, Federal Reserve Chairman Paul Volcker, appointed in 1979, instituted a series of severe monetary contractions to restrict liquidity, push up funding costs and induce a deep recession to break the back of inflation. Though politically damaging, the strategy proved effective at stopping inflation’s momentum by 1982.

Volcker’s Fed raised the federal funds rate, which banks charge each other for overnight loans, from 11.2% in 1979 to a peak of 20% in June 1981. This caused the prime rate, which banks charge their best customers, to rise to 21.5%. The economy plunged into recession, with GDP falling 2.7% from peak to trough and unemployment soaring to 10.8% by late 1982.

[Include a chart showing the federal funds rate and unemployment rate during the early 1980s]

Supportive supply-side fiscal policies, championed by President Ronald Reagan, also played a role in the recovery. Reagan pushed through significant tax cuts, reduced regulatory burdens on businesses, and launched a major defense buildup. While controversial, these policies helped spur productivity growth and entrepreneurship.

Lessons Learned

The Great Inflation demonstrated how anticipations of continually rising prices can become deeply embedded in the economy and require deliberately engineered recessions to reverse once underway. It transformed economic policymaking philosophy going forward in several key ways:

• Central banks became more focused on price stability as their primary mission, and more willing to raise interest rates proactively to prevent inflation from accelerating.
• Governments became more cautious about running large budget deficits and printing money to finance spending, recognizing the inflationary risks.
• Economists placed greater emphasis on the role of inflation expectations in driving actual inflation, and the importance of central bank credibility in shaping those expectations.
• Supply-side policies aimed at boosting productivity growth and expanding economic capacity gained greater prominence as a way to enable non-inflationary growth.

While the Great Inflation was a painful episode, policymakers learned valuable lessons that have helped keep inflation low and stable in the decades since. By staying vigilant against inflationary pressures and maintaining a strong commitment to price stability, central banks and governments can help ensure a more prosperous economic future.

Related Terms:

• Stagflation: A condition of slow economic growth, high unemployment, and high inflation
• Misery Index: The sum of the unemployment rate and the inflation rate, used as a measure of economic distress
• Supply Shocks: Sudden disruptions to the supply of key commodities or goods that can cause prices to surge
• Overstimulation: When government policies, such as excessive spending or money printing, drive up aggregate demand and inflation
• Accommodative Monetary Policy: When central banks keep interest rates low and money supply growth high to stimulate borrowing and spending
• Demand-Pull Inflation: Inflation caused by too much demand chasing too few goods, often due to overstimulative policies
• Cost-Push Inflation: Inflation caused by rising costs of production, such as from higher raw material or labor costs, which businesses pass on to consumers
• Reaganomics: The supply-side economic policies championed by President Ronald Reagan, which aimed to boost growth through tax cuts, deregulation, and smaller government
• Phillips Curve: An economic model suggesting an inverse relationship between unemployment and inflation, which came under scrutiny during the stagflationary 1970s
• Monetarism: The economic theory, associated with Milton Friedman, that focuses on the role of money supply growth in driving inflation and the business cycle, and which gained influence in the wake of the Great Inflation.