That ‘70s Show

Worried, but not that worried!

A hot buzzword is the past week or so is “Stagflation.” According to CNN: nbsp;“Stagflation fears just hit Wall Street.” nbsp;Some even see a risk of a replay of the 1970s. For example, Fortune reported that “JPMorgan’s Jamie Dimon can’t shake the worry America is headed for a repeat of 1970s-style stagflation.”

How concerned should we be? Let’s first compare the data for the two periods and then explore the historical backdrop. While I’m concerned about a very mild case of stagflation—weak growth and high inflation—a replay of the 1970s would require both very bad luck and very bad Fed policy.

The bad old days

There is no question that the 1965-82 period was disaster for the US and the global economy. Inflation rose to successively higher peaks in 1970, 1975 and 1980 (blue line on the chart). There were four recessions, including two of the biggest in the post-war period – 1974 and 1982. Put the two together and it was a period of very bad “stagflation.”

This can be illustrated with the Misery Index, a simple sum of the unemployment rate and CPI inflation (orange line in chart). The Misery Index peaked at over 20% in both 1974 and 1980 and was almost continuously above 10% from 1969 to 1993. No other period comes close in the modern era.

In the current cycle, the index briefly peaked at 15% and then again at 12%. However, the latest reading for March is just 7.3% or about 2% below its historic average.

Of course, the recent cycle of inflation is far from over, which begs the question: could things get a lot more miserable? I doubt it: there are five major differences between today’s economy and the ‘70s disaster. No need to stockpile water, guns and Dinty Moore beef stew.

A flattish, stable Phillips curve

One common theme in both periods was a strong belief in a relatively benign Phillips curve. The original Phillips curve assumed a permanent trade-off between unemployment and inflation. It implied that policymakers could push the unemployment rate permanently below its historical average at the cost of only modestly higher inflation.

In the late 1960’s both Milton Friedman and Ned Phelps argued that the relationship was not stable – that if the central bank tried to exploit the curve, inflation expectations would rise, shifting the curve upward. In the “accelerationist Philips curve” unusually low unemployment could be maintained only with an ongoing acceleration of inflation as workers and firms demanded more and more “inflation compensation.” Unfortunately, it took a number of years for this to become the mainstream view.

In the current cycle, there was a similar but much shorter-lived bit of wishful thinking. The Fed’s 2020 strategy leaned heavily on the idea that inflation expectations are “well anchored,” and that the Phillips curve was structurally almost flat. Hence the initial Fed response to inflation in 2021 was to argue that it was almost all “transitory” and therefore did not require an immediate policy response.

This was a major error and is similar to what happened at the start of the Great Inflation. However, the difference in this cycle is that the Fed quickly woke up to reality. In 2022, they shifted from falling well behind the curve to rapidly catching up, with one of the fastest tightening cycles in history. They correctly zeroed in on the importance of avoiding an unanchoring of inflation expectations to the upside and the resulting upward shift in the Phillips curve. Thus far this anchoring effort is reasonably successful. Wage and price controls In other respects, today’s cycle looks even more different than in the 1970s. One of the biggest policy mistakes in the modern era was the adoption of wage and price controls in 1971. They created the illusion that inflation could be brought under control without disciplined monetary and fiscal policy. They acted like a cover on a pressure cooker, causing massive distortions in the economy while artificially constraining inflation. Once they were released, pent-up inflation boiled over.

A less important bit of wishful thinking in the 1970’s was the idea of trying to talk down inflation. President Ford issued “Whip Inflation Now” buttons for people to wear in solidarity around containing inflation. As an aside, this button came in handy when I was an economist at the NY Fed. At a pre-FOMC briefing on inflation at the NY Fed I wore a WIN button and got a good laugh.

Today there are echoes of this with attempts to talk down profits and take anti-trust actions to bring inflation down. Like the WIN buttons, this not an effective strategy.

Supply shocks

Another difference between the two periods is the impact of supply shocks.

The commodity shocks of the 1970s were like bolts out of the blue. Economic models didn’t even include food and energy prices.  Hence economists struggled to forecast the impact on the macroeconomy and the Fed wasn’t sure how to respond. The general public was also confused and reacted to the jump in prices by expecting more to come. Inflation expectations became unanchored.

By contrast, today economists, policy makers and the general public have grown accustomed to temporary supply shocks. Policy-makers understand the importance of looking at the “second round effects” of supply shocks on wage and price setting. Meanwhile, after many years of temporary supply shocks, workers and business leaders have gotten used to looking through them and there is a much smaller impact on wage and prices behavior. All of this makes today’s shocks easier to manage.

Adverse structural shifts

More permanent structural changes in the supply-side of the economy added to both inflation risks and policy errors by the Fed in the 1970’s. We now know with the benefit of hindsight that trend growth in GDP dropped after the first oil shock in 1973. Looking back in time, the CBO estimates that trend growth slowed by about a percentage point over this period. At the same time, the inflation-neutral unemployment rate (NAIRU) was trending up to 6%, compared to a popular 4% rule of thumb coming into the period.

All of this contributed to an overly easy monetary policy. Fed officials puzzled over why inflation remained so high despite slower growth and a higher average unemployment rate. This is a stark reminder that “star” variables, like trend growth and NAIRU should be constantly reassessed.

Today, history could repeat itself, but again historical experience has made forecasters more alert to these kinds of shifts. Thus far it is not clear whether trend growth in the economy is accelerating or decelerating. On a negative note, the oil shock caused structural changes in the economy in the ‘70s, and COVID, deglobalization, global warming and so on could do the same today. On a positive note, if the true believers are right, AI could be transformative for productivity and trend growth.

As for NAIRU, the tentative evidence so far is that it is also relatively stable. While core inflation has been a rollercoaster ride — first a sharp drop then a sudden rise—overall the drop in year-over-year inflation has been about as expected. This suggests that NAIRU has not moved notably higher.

Matador defense by the Fed

Last, and most important, the Fed simply did not do its job of controlling inflation in the 1970’s. Supply side shocks only lead to sustained inflation if they are accommodated by the central bank. That applies not just to the supply-side shocks of the 1970s, but to today’s supply-side challenges. If deglobalization, climate change and other shocks add to business costs and slow trend growth, the central bank needs to act accordingly to contain inflation.

In the ‘70s Chair Burns lost confidence in the Fed’s ability to fight inflation. He invented the idea of core inflation and then expanded it to fit his narrative, first excluding food, then energy, and then a variety of other hot spots. He blamed labor unions, monopoly power and other rigidities in the economy for inflation. He was a major advocate for price controls as a substitute for disciplined monetary policy. He also seemed to accept the idea that the Fed did not have the political backing to hurt the economy enough to bring inflation down.

But what about today? To be honest, in late 2021 I was beginning to worry bit about a Burns replay. The Fed seemed to be ignoring strong signals from measures of the breadth of inflation, such as the trimmed mean. They stuck to the idea that the Fed should focus on outcomes rather than forecasts, even as unemployment trended lower and core inflation trended higher. The only forecasting tool you needed was a rubber band to extrapolate where things were headed. The Fed also stuck to the idea of a slow, predictable transition from QE to rate hikes.

By contrast, I was impressed at how aggressively the Fed pivoted in 2022. By the summer, the Fed had figured out that it was seriously behind the curve and started to hike in big chunks. Once the funds rate moved above 5%, I felt like they were basically where they should have been six months earlier. It was a risky shift, and it did help trigger a regional banking crisis, but it helped push inflation lower.

Of course, another test lies ahead if inflation remains stuck above target. I think the Fed will pass the test for two reasons. First, the cost of getting inflation down should be either flat or modestly negative growth. It would be very surprising if it required a 1974- or 1982-sized recession. Second, the Fed has (deliberately) tied its hands with its insistence that the target is 2% and needs to be achieved in a reasonable timeframe. Indeed, as I have noted before, the FOMC’s Summary of Economic Projections is useful in that it puts down in black-and-white both the long-run 2% objective and the steady convergence members think is consistent with appropriate monetary policy.

Not so miserable

My guess is that the Misery Index will actually fall a bit further in the year or two ahead, settling at around 7%. This is because inflation is likely to ease by more than the pick-up in the unemployment rate. Even with a bad outcome, with a mild recession and sticky high inflation, my guess is the Misery index would only rise to about 8% or so. If the unemployment rate rises to 4.5% to 5.0% and CPI inflation remains at 3.0 % to 3.5% then the Misery Index will be 7.5% to 8.5%. That is still below its historic average of 9.2%.

The common theme in this brief history lesson is that economists and policy-makers have learned from the mistakes of the 1970s, making a replay unlikely. In the fall of 2021, the US took one step down the path to the ‘70s, but decisive action in 2022, largely offset that mistake. If you are looking for reruns of That 70’s Show you can stream it on Peacock or purchase it on Amazon.