With all of the problems afflicting the world economy nowadays, inflation seems to be the least of our worries. In addressing the post-2008 economic malaise, which stems from over-indebtedness, policymakers are correct to focus on the threat of debt deflation, which can lead to depression.
However, dismissing inflation as “yesterday’s problem” could undermine central banks’ efforts to address today’s most pressing issues –— and, ultimately, facilitate inflation’s resurgence. Understanding how the Great Inflation from the late 1960s to the early 1980s was tamed offers important lessons for addressing far-reaching economic problems, however different ours may be, and provides insight into the dangers that may lie ahead.
The first useful lesson concerns expectations. In the decades following World War II, the doctrine that inflation needed to be traded off against employment — based on the relationship that William Phillips described in 1958 — dominated economic thinking. However, the Phillips curve fared poorly in the 1970s, when many countries experienced “stagflation” (high levels of both inflation and unemployment).
This vindicated criticism by Milton Friedman and Edmund Phelps, among others, who had already begun to argue that the Phillips curve represented merely a short-term relationship. If people do not expect inflation, the illusion of increased purchasing power can boost employment and output for a relatively short period. Once workers realize that real wages have not increased, unemployment will return to its “natural” level consistent with stable inflation.
Later, “new classical” economists like Robert Lucas and Thomas Sargent demonstrated that once people understand that inflation is being manipulated to generate market optimism, the monetary authorities’ actions lose their impact. The result is higher prices and no job creation.
These ideas, combined with effective policy practice like that of the US Federal Reserve under Paul Volcker’s chairmanship, led many countries toward more explicit inflation targeting, in which central banks stabilize inflation expectations by making a credible commitment to a predetermined rate of price growth. By the 1990s, inflation was old news in the advanced economies, with much of the developing world soon to follow.
Today, the Fed is again playing the expectations game. However, in order to stave off the threat of deflation and depression, it is targeting a lower unemployment rate, below 6.5 percent. As progress toward that target is made, US Federal Reserve Chairman Ben Bernanke announced in late May, the Fed will begin to “taper” its program of long-term asset purchases known as quantitative easing (QE).
That prospect has already sparked renewed financial-market volatility. In July, Bernanke attempted to calm investors with remarks signaling that, amid inadequate employment gains and persistently low inflation, the Fed would not abandon monetary stimulus anytime soon.
This stance reflects the Fed’s dual mandate, according to which monetary policy targets maximum employment consistent with price stability. However, the credibility needed to anchor expectations is difficult — sometimes even impossible — to achieve when two targets are being pursued simultaneously. The resulting uncertainty could trigger more volatility, especially in bond markets, potentially impeding economic recovery (for example, by pushing up long-term mortgage rates) or augmenting future inflation risk.