The Great Inflation of 1970s

As per the World Bank data, Inflation in the US started picking up in the year 1965. The annual percentage change of Inflation in the year 1965 was 1.6%. And, it touched a high of 13.5% in 1980. From there it took 6 years to get it back to a 1.9% annual percentage change.

How did it start?

After the end of World War II, numerous steps were taken by Congress to promote economic stability. One such step resulted in the Employment Act of 1946. As per Section 2 of the Employment Act of 1946, Congress declared that it is the responsibility of the Federal Government to promote maximum employment, production, and purchasing power.

Back then, it was observed from the available data that economies prosper and collapse in cycles. So, a period of prosperity is followed by despair. As per Keynes, we can stabilize economic activity through appropriate fiscal and monetary policies.

In the 1960s, it was believed that we may have to deal with moderate inflation in order to achieve a low level of unemployment. It came from Phillips Curve, which represents the inverse relationship between unemployment and inflation in the short run.

In July 1944, a new monetary system, the Bretton Woods system was created. But, it was only in 1958 the system become fully functional. As per the system, countries had to settle their international balances in dollars while the dollar itself was convertible to gold at a fixed exchange rate i.e. $35 an ounce. But, it created a “dollar glut” abroad.

In 1960, Robert Triffin warned of flaws in the international monetary system. To provide the world the liquidity, the US ran a balance of payment deficit. The dollar reserves with the central banks of Europe and Japan were redeemed for gold, which impacted the US gold reserves. There was a time when dollars held abroad were far higher than the gold the US had. So, it resulted in an erosion of confidence in the dollar’s convertibility to gold.

By the mid-1960s, inflation had begun to rise. Policymakers tried to bring that down with appropriate monetary and fiscal policies. But, it proved ineffective. In the late 1960s, both inflation and unemployment were rising. And, Fed believed that the rise in inflation was due to factors that were beyond its control. So, it considered employment as its first priority and continued with its expansionary monetary policy.

In response to the increasing inflation, in 1971 US President Richard Nixon took a series of measures which included a freeze on wages & prices, the dollar could no longer be converted to gold by foreign central banks.

Two energy crises: 1973-74 & 1978-79 Oil Shock exacerbated the economic conditions. Unemployment was rising and the rise in the price of oil was something that Fed couldn’t control. So, Fed continued with its expansionary monetary policy to ensure unemployment stay low. Though the Nixon administration tried to halt rising inflation by implementing a freeze on wages and prices. But, such tools ultimately proved ineffective.

In the 1980s, Fed slowed the reserve growth and continued to hike interest rates. The interest rate hike cycle which started in May 1977 at 5.35% hit a high of 19.10% in June 1981. And, that halted the rising trajectory of inflation and brought it back to acceptable levels. And, it marked the end of the Great Inflation.

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