Inflation: Return of the Dragon

It was nearly forty-three years ago that Paul Volcker stood before the Washington press corps and announced a radical shift in America’s monetary policy. “The basic message we tried to convey was simplicity itself,” he would recall later. “We meant to slay the inflationary dragon.”

Volcker was President Jimmy Carter’s new pick to head the Federal Reserve, and everyone knew he had a tough job ahead of him. Inflation was over 6 percent in 1977, the first year of Carter’s presidency. By 1979, it had skyrocketed to 11.25 percent. The economy was in deep trouble. It would take bitter medicine to set it right again.

The tight money policies that Volcker introduced led inevitably to a painful recession. Unemployment peaked at 10.8 percent in November 1982. But inflation slid steadily downward, dropping to 3.2 percent in 1983. Volcker’s medicine worked—at great cost to both consumers and the Carter administration. The accompanying recession certainly contributed to Carter’s loss to Ronald Reagan in the 1980 election.

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In the decades since then, many Americans forgot the economic disruption that inflation can bring. It has remained only a distant threat—until now.

A Renewed Menace

Consumer prices this March rose 8.5 percent over the previous year—the biggest jump since the recession days of 1981. The month-over-month increase was even more ominous, at 1.2 percent. Extrapolate that over a twelve-month period and the prospects become truly alarming.

Predictably, the causes of this inflationary trend are a subject of hot political debate. Republicans blame the Biden administration while Democrats blame Vladimir Putin and the oil companies.

But at the most basic level, inflation is a simple matter of supply and demand. It’s often described as “too much money chasing too few goods.”

As in the 1970s, oil is certainly a factor in our current dilemma. Back then, the Organization of Petroleum Exporting Countries (OPEC) engineered two successive oil shortages that drove prices upward across the board. The price of oil affects transportation, manufacturing, farming, and virtually every other economic sector. Consumers felt the pinch, just as they are beginning to now.

Russian President Vladimir Putin’s invasion of Ukraine in February 2022 definitely had an impact on oil prices. But they had already been climbing, starting in August 2021. Consumer prices in general began rising significantly the previous April and never fell below an annualized rate of 5 percent after June.

At least three other factors were the more likely culprits in inflation’s reemergence:

  • Low interest rates,
  • The COVID pandemic, and
  • Government spending.

Let’s consider each one.

Easy Money

Since 2009, the Federal Reserve Board has pursued a policy of “quantitative easing,” basically making money more available for businesses and consumers. The Fed’s historically low interest rates made borrowing easy and attractive. And by purchasing government bonds at a rapid pace, the Fed injected large amounts of cash into the private economy.

The intended effect was to keep the economy humming, and it worked. Critics warned that these cheap-money policies would lead inevitably to inflation, but that failed to materialize—until now.

The Contraction That Wasn’t

When the COVID pandemic hit, businesses across the country were locked down. Millions of workers hunkered down at home. Planners and pundits predicted that consumer spending would plummet as a result. In anticipation, many businesses curtailed production, laid off workers, or shut down altogether.

But consumers were still consuming. They simply shifted to online purchasing—even more than before. Consumer spending indeed dropped in the first quarter of 2020, when the pandemic hit hard, but it quickly recovered.

As the lockdowns eased, consumers got back in the game with a vengeance. Demand for many goods outstripped the available supply. And, no surprise, prices spiked on nearly everything.

And More Easy Money

In response to the COVID pandemic, the federal government reverted to its most primal behavior—spending money.

It began with the Coronavirus Aid, Relief, and Economic Security (CARES) Act, signed into law by President Trump in March 2020. At $2.2 trillion, this was the largest economic stimulus package in US history. It included $260 in increased unemployment benefits, $350 billion in loans to small businesses (later increased to $669 billion), $500 billion in corporate loans, $339 billion to state and local governments, and $300 billion in direct cash payments to families and individuals.

When President Biden took office, the spending spree continued. His Infrastructure Investment and Jobs Act, signed in November 2021, directed approximately $1 trillion to various projects, including roads, bridges, rail transport, public transit, ports, airports, safety programs, low-emission buses and ferries, clean water, pollution mitigation, electric vehicles, and “community revitalization.”

With all this money floating through the economy, prices were bound to rise. Combined with a supply chain bottleneck that few foresaw, the result was a perfect storm of inflationary pressure.

Will the Cure Work This Time?

In March 2022, the Federal Open Market Committee—the policymaking body of the Federal Reserve—announced a quarter‑point rise in the Fed Funds rate. That increase will ripple through the economy in the form of higher rates for mortgages, car loans, business loans, and other credit transactions. The Fed also signaled the likelihood of six further increases this year.

This is a conventional response to the threat of inflation. But some observers wonder if it will work this time. The nightmare scenario is that people might begin to see inflation as a permanent fact of life. They could then raise prices reflexively and continually. Salary demands could follow suit. And inflation then becomes a feedback loop with no end in sight.

Buckle up—and stay tuned.

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