Whither Inflation?

Whether we’re able to get past high inflation in a year or two will depend in large part on how well we move past COVID. Here’s why.

By Richard Vague

Tagged Economicsinflation

On January 12, 2022, the U.S. Department of Labor announced that the consumer price index rose 7 percent in the 12 months ending December 2021, following increases of 6.2 and 6.8 percent in October and November, respectively. These price increases are hitting lower- and middle-income Americans hard, which raises the urgent questions of how high this inflation will go and how long it will last.

I’ll get straight to the point: We’re going to have reasonably high inflation for a year or two before a return to moderate or low pre-pandemic levels. In any given month during this time, we could see high single-digit or even low double-digit inflation—but even these higher figures fall well within historical norms. This all follows very low inflation in 2020.

My prediction of a return to lower inflation depends on getting past COVID, or at least learning to live with it, so that people can return to jobs in food processing, goods manufacturing, and supply distribution—all the elements of the supply chain. If COVID lasts longer (or we don’t adjust to life with the virus), then so will inflation.

Other forecasters, including the Federal Reserve, believe this inflation will be short-lived. Yet there is broad distrust among voters of government forecasts as self-serving, and widespread awareness of the recent unprecedented levels of new government debt and money supply growth. Many believe this will bring longer-term high inflation, based on a monetary theory popularized by economist Milton Friedman in the 1970s and 1980s. He argued that excessive money supply growth (often wrongly conflated with government spending in popular opinion) would cause the value of money to decline and thus bring higher inflation.

The generation that came of age in the high inflation period of the 1970s and early 1980s has long been obsessed by inflation, seeing it around every corner, and many are certain that high government spending and money supply growth bring high inflation.

Yet we can readily demonstrate that they do not.

The first place to look is Japan, where inflation has been near zero for a generation, including in 2021, yet its government spending and monetary growth dwarf our own—at year end of 2020, Japan had 256 percent government debt to GDP compared to our 133 percent, and a money supply equal to 211 percent of GDP compared to our 91 percent.

A second place to look is the United States after the 2008 crisis, when government stimulus and support brought high money supply growth without bringing high inflation.

In fact, inflation has rarely been a problem in U.S. history or in large, developed countries generally—and never the sort of high double-digit or triple-digit inflation that has plagued many less developed nations. Among economic calamities, including banking crises, stock market crashes, currency collapses, and more, inflation has impacted the world least on a GDP-weighted basis.

Since 1800, the United States has had only eight notable bouts of inflation, defined for our purposes as two or more years of inflation above 5 percent.

Four of these bouts were the all-but-inevitable consequence of major wars. These occurred from 1812 to 1814, with a peak of 15.8 percent annual inflation in the War of 1812; from 1862 to 1864, with a peak of 34.4 percent in the Civil War; from 1916 to 1920, with a peak of 17.9 percent in World War I; and from 1941 to 1948, with a peak of 14.4 percent in World War II.

This war-related inflation happened because demand grew yet supplies were decimated. Soldiers were fighting and could not work in farms and factories. Farms became battlefields without crops, factories were repurposed or destroyed, and prices skyrocketed. Call it “supply-depletion” inflation. This inflation ended abruptly as war spending abated, soldiers came back, battlefields reverted back to farms, and factories were rebuilt.

As for the non-major-war-related spikes, the first was a brief bout of high inflation that occurred in 1804 and 1805, peaking at 9.2 percent, but it was both preceded and followed by price collapses that more than offset this inflation in the still-bumpy early years of the republic. A second bout happened in 1835 and 1836, peaking at 9.2 percent as a result of an unprecedented lending boom, but that boom led to America’s third economic depression and a near decade of murderous price deflation.

The mildest of these bouts with inflation occurred from 1969 to 1970, when annual inflation peaked at 5.9 percent—a tame figure compared to war-linked inflation. Orthodox economists blamed this inflation on “guns and butter” spending during the Vietnam War, the decision to pay for that war with deficit spending rather than by cutting expenses or raising taxes. But that explanation doesn’t hold up particularly well as the ratio of government debt to GDP actually declined from 43 percent in 1965 to a very low 33 percent in 1972. (The Vietnam War had far less impact than America’s major wars. Its expense to GDP peaked at roughly 10 percent, while in World War II it exceeded 40 percent, and that war was isolated to a small geography that did not dent the world’s productive capacity.)

Instead, the most notable factor among others was the determination of the United States to defend the Bretton Woods-era gold standard of $35 an ounce even as the dollar had begun to weaken, allowing foreign governments to redeem their dollars for gold at $35 an ounce and then sell it at a higher price in foreign markets. Despite efforts to intervene, especially by raising interest rates, U.S. gold supplies plunged from 20 thousand to less than 10 thousand metric tons during the decade.

The very sale of so many dollars further weakened the currency, making imports expensive and contributing to inflation. Interest rates peaked in 1969 at 6.7 percent, while inflation peaked at 5.9 percent in 1970. The United States actually began raising rates before the appearance of inflation in 1966, and since raising interest rates makes things more expensive this decision itself may have contributed, ironically, to the rise in inflation. But it wasn’t enough to stem the gold outflow, so President Richard Nixon took the United States off the gold standard in 1971 and inflation fell back to 3 percent in 1972.

The last major bout of U.S. inflation lasted from 1973 to 1982, peaking at a 13.5 percent annual rate in 1980, and this is the inflationary episode that is seared in the minds of a generation of economists. Although caused by several factors, this inflation was largely a function of high oil prices.

In August 1973, the price of oil jumped by 21 percent on fears of the impending Yom Kippur War, and in response, inflation jumped from 5.7 to 7.4 percent. The Arab nations embargoed oil exports to the United States in retaliation for its support of Israel and by January 1974 oil had risen from $3 to $10 a barrel, sending inflation to 12 percent that same year. In 1980, on the heels of the Iranian Revolution and a resulting collapse in oil production, the price of oil shot up further to $39, which was the largest factor in pushing inflation to 13.5 percent.

Nixon had capped domestic oil prices in 1971, which curbed domestic exploration efforts and helped further cede oil price leadership and dominant market share to the Saudi-led oil cartel, OPEC.

Infamously, Fed Chairman Paul Volcker, following the views of Friedman, saw that period’s inflation more as a result of money supply growth than oil prices, and in 1979 hiked interest rates to double digits to curb that growth, precipitating a severe U.S. recession.

But the Friedman/Volcker view of inflation falters under scrutiny, even beyond the examples of Japan and the Great Recession provided earlier. When we examine the largest countries in the world, we see that benign inflation is sometimes preceded by either high money supply growth or high government debt growth, and that episodes of high inflation occur that do not follow either of those conditions.

In fact, money supply growth was still very high in 1986 when inflation was a mere 2 percent—which showed that Volcker had not succeeded in reducing money supply growth by much and yet inflation had still plummeted.

The true solution to inflation was the deregulation of the price of domestic oil, a process finalized under Ronald Reagan. This spurred a boom in domestic production that brought the price of a barrel of oil back down to $28 in 1982 and then to $11 in 1986, sending inflation back down to 6 percent in 1982 and 2 percent in 1986.

Some believe consumer expectations drive inflation, but that episode of high inflation, like most others, arrived and departed despite consumer expectations to the contrary. And the lesson regarding petroleum dependence was at least somewhat heeded. Forty years later, U.S. oil market share is up, OPEC’s is down, and the United States now consumes 30 percent less petroleum per capita due to the improved efficiency of automobile engines and other petroleum-related processes.

Our current COVID-based inflation most closely resembles the war-based bouts of inflation, since it is largely a function of a depleted workforce, decimated supplies, and impaired supply chains. (Note that the Spanish Influenza pandemic at the end of World War I was part of what kept U.S. inflation high through 1920.) Although demand collapsed initially during the COVID crisis, it is now restored due to unexpectedly bold financial stimulus from Congress and market support from the Fed. With that combination, inflation could yet go higher—but still fall within the bounds of earlier “supply-depletion” inflation.

Rising oil prices are part of the story, which has led some to compare our current inflation to the 1970s, but their impact should return to an acceptable range since per capita oil consumption is markedly lower. Notably, oil prices have been much higher within recent decades without causing high inflation.

Rising home prices and apartment rents are also a supply-depletion problem. Following the 2008 crisis, the housing industry was fearful of building too much inventory, and on the eve of the pandemic the housing inventory was exceedingly low—less than half that of 2007. When the fear of contagion brought a mad rush to buy houses located further away from population centers, often with buyers who had not sold their existing homes, prices had nowhere to go but up.

This inflation will decline as stimulus support ends, as the fear of COVID abates, and as people re-enter the workforce—especially workers for the trucks, rails, and ships that carry food and goods, workers who make or process those foods and goods, and workers in construction. High prices will recede as disrupted output levels are improved and supply chains unclogged. But with Omicron and other variants yet to come, it could take at least a year or two to get past COVID, or learn to live with it. Supply chain and other operating problems always take longer than expected to resolve.

That return is further complicated and delayed by the widespread terminations, resignations, lifestyle re-evaluations, and reluctance to return to work occasioned by the pandemic. In fact, this tight labor market is unique in that it is due to workers exiting, when favorable economies typically pull marginal laborers in. But workers eventually will return, even if it takes structural changes in salaries and circumstances.

And economic trends still point toward slower growth and thus lower inflation.

A big part of these larger economic trends is due to slowing population growth, which is now at its lowest rate in U.S. history. Some posit that a smaller workforce will put upward pressure on wages, but Japan’s decades of scant population growth have shown the opposite to be true, since low population growth also brings lower demand.

Another economic trend relevant to lower inflation is the relentless march of automation, and there has never been a period in history with as much motivation and wherewithal for that. Zoom has reduced the need for travel, and Docusign the need for paper, pens, and mail. This list goes on and on. I dined at a restaurant recently where I used my phone to read the menu, place our order, and even pay. There were no waiters—only staff who wordlessly brought the order to our table. Employers, chastened by their vulnerability to worker absence, are now working even more energetically to find ways to reduce staff.

The decoupling of the United States and China will put some upward pressure on inflation, but it will only add to the rush to automation and bring an accelerated trend of both the search for alternative nations that provide inexpensive manufacturing, and the select reshoring of more automated manufacturing.

Further, the current burden of student loans, “buy now pay later” programs, health-care debt, credit cards, and more on U.S. households also slows economic growth, since people must divert income to pay interest and principal.

Nevertheless, with inflation on the rise, the Fed is already contemplating raising interest rates. But that is a terribly clumsy, blunt-force tool designed to slow down growth and thus inflation by, in effect, bringing broad harm to both those sectors of the economy that contribute to inflation and those that don’t.

Importantly, interest rate increases today have more than twice the economic braking impact that they did in 1979 during Volcker’s tenure, since total debt to GDP is now a whopping 130 percent higher than it was then. That means an increase in short-term rates from the current near-zero rate to 5 percent would strangle as much growth and bring as much trauma as when Volcker’s actions pushed short-term Treasury bill rates from 5 percent to 14 percent in 1981.

So, prepare for inflation for a year or two or more, depending on COVID and how well we learn to live with it, and a return to moderate or lower inflation after that. And we should be judicious in the use of higher interest rates to quell inflation, since the abatement of the pandemic that will bring returning workers and untangled supply chains will do the job without those rates.

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Richard Vague is author of The Paradox of DebtThe Case for a Debt JubileeAn Illustrated Business History of the United StatesA Brief History of Doom, andThe Next Economic Disaster. He is a former banking executive and the former Secretary of Banking and Securities for Pennsylvania.

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