, Federal Reserve Bank of Atlanta.
The Great Inflation was the defining macroeconomic event of the second half of the twentieth century. Over the nearly two decades it lasted, the global monetary system established during World War II was abandoned, there were four economic recessions, two severe energy shortages, and the unprecedented peacetime implementation of wage and price controls. It was, according to one prominent economist, “the greatest failure of American macroeconomic policy in the postwar period” (Jeremy Siegel 1994).
The Fed’s Faulty Phillips Curve
The painful inflation starting in the late 1960s was partly due to a prevailing post-Great Depression mindset. Notably, high levels of unemployment were unacceptable. To this end, the Employment Act of 1946 tried to coordinate monetary and fiscal policy “to promote maximum employment” along with a strong economy.
As we will discuss later, The Federal Reserve Act of 1977 amended the Fed’s objectives to add stable prices and moderate long-term interest rates with maximum employment. However, before 1977, the Fed’s primary objective was low unemployment. At the time, higher inflation levels, while not desired by the Fed, were an acceptable byproduct of meeting their employment objectives.
To help set policy, the Fed put a lot of faith in the Phillips Curve. The theory claims that inflation and unemployment have a reliable and inverse relationship.
The graph below shows the inverse relationship between inflation and unemployment between 1960 and 1970. The Phillips curve proved very reliable during that period, further bolstering the Fed’s trust in the model.
Like many economic models, the Phillips Curve does not account for human behavior and rational decision-making. In this case, the Fed failed to consider that rational human behavior would cause the Phillips Curve to shift outward. The Fed didn’t expect businesses and consumers expecting inflation to change their behaviors in ways that promote more inflation.
For example, auto demand may increase because consumers rush to purchase new cars today instead of tomorrow in anticipation of higher prices. Similarly, auto manufacturers may increase prices today, anticipating metal prices will rise tomorrow.
The following graph shows the once dependable Phillips Curve of the 1960s, failed policymakers in the 1970s. Higher levels of inflation accompanied higher unemployment. With each peak higher in inflation, unemployment also reached new highs.
Nixon Removes The Fiscal and Monetary Shackles
Not only was the Fed relying on a faulty economic theory, but its ability to administer monetary policy was greatly amplified on August 15, 1971.
The following comes from our article entitled The Fifteenth of August.
August 15, 1971, was the date that President Richard Nixon shocked the world when he closed the gold window, thus eliminating the free convertibility of the U.S. dollar to gold. This infamous ‘new economic policy’, or “Nixon Shock”, thereby removed the requirement that the U.S. dollar be backed by gold reserves. From that fateful day forward, constraints that previously hindered the Federal Reserve’s (Fed) ability to manage the U.S. money supply were removed.
With Nixon’s signature, the Fed could use monetary policy more aggressively to meet its employment goals. Equally inflationary, the government no longer had to worry that rising fiscal deficits would spur gold redemptions. Fiscal imbalances ran high due to Vietnam and increased spending to promote stagnant economic growth. The government no longer had to choose between guns OR butter. It could pay for guns AND butter.
President Nixon removed essential checks and balances on fiscal and monetary policy. The collective actions added to inflationary pressures.
Summary Part One
Part One begins to set the table, allowing us to appreciate some of the causes of the inflation that ravaged America from the late 1960s to the early 1980s. Part Two will continue the conversation by discussing the oil price shocks, price-wage spiral, and details on how the money supply augmented in