Inflation is reaching alarming levels – 6.2 per cent in the U.S. in October, the worst in 31 years – making it more expensive to buy food or fill up the tank. But steadily rising prices won’t last forever, because economists and central bankers have learned the hard lessons of the 1970s.
The problem is that the cure for inflation is higher interest rates. And that can be painful, too.
It’s worth remembering what brought on the The Great Inflation half a century ago, and all the grief that came with it.
In the 1960s, the Vietnam War and major social reforms pushed up deficits in the United States. In 1971, president Richard Nixon ended the convertibility of U.S. dollars into gold, which created confusion over the real value of currency. And then, in 1973, the oil producing nations of the Middle East imposed an embargo to punish the U.S. and other nations for supporting Israel in the Yom Kippur War. With prices doubling, then quadrupling, much of the West fell into recession.
To fight unemployment, governments and central banks stimulated their economies, believing they could manage the resulting inflation. That was a huge mistake.
“There was a feedback mechanism where prices were rising, people expected their wages to rise, and they bargained for that, and that in turn led prices to rise again,” said Michael Smart, a University of Toronto professor of economics and co-director of Finances of the Nation, a think tank. “And that expectation of future inflation got baked in.”
No one knew how much prices might go up. Unions fought for higher wage increases for workers. It seemed like everyone was on strike. Businesses cut back on investment because things were so uncertain, throwing people out of work. Canada and the U.S. sank into the worst of both worlds: high and unstable inflation, coupled with rising unemployment. Stagflation.
It was awful. People couldn’t plan for the future. Jobs weren’t safe. It felt as though America and Canada were in decline, that good times would never return. First in the U.S., and then in Canada, governments responded with wage-and-price controls. But that only ratcheted up inflation once the controls were lifted. President Jimmy Carter never actually said America was afflicted with a “malaise.” But everyone thought he did and he might as well have. And then, to bookend the misery, in 1979 oil prices shot up again in the wake of the Iranian revolution, another shock to the economy.
That was the year Paul Volcker, chairman of the Federal Reserve, decided to lick inflation once and for all, by ratcheting up interest rates. The Bank of Canada followed suit. That was awful, too. Mortgage rates in Canada peaked at over 21 per cent in 1981, and unemployment peaked at 12.8 per cent a year later. Imagine trying to get a mortgage or a job in such times. People were miserable.
“The cost of eliminating inflation is really high,” said Michael Devereux, a professor of economics at University of British Columbia. Expectations of double-digit inflation had become so entrenched it took crippling interest rates and a major recession to break the cycle. “That’s why we had such a high cost with the Volcker disinflation.”
But the medicine worked. Inflation came down and stayed down. With prices stable, businesses began investing again and jobs came back. Life was good.
In the late 1980s, the Bank of Canada’s governor, John Crow, decided inflation was still too high and sent interest rates up again, which contributed to another serious recession. But inflation eventually fell to 2 per cent and has stayed there since. Another round of belt-tightening followed finance minister Paul Martin’s decision in 1995 to eliminate the federal deficit, but from 1997 until the pandemic struck – with the exception of the financial crisis of 2008-09 – inflation, interest rates, unemployment and deficits have all stayed within reasonable limits.
Now inflation is back, mostly the result of supply chain disruptions and increased spending by consumers, as the pandemic eases. But governments and central banks have made it clear they have no intention of allowing it to become embedded.
“I came of age and studied economics in the 1970s and I remember what that terrible period was like,” Treasury Secretary Janet Yellen said this year. “No one wants to see that happen again.”
But the only way to fight inflation is to raise interest rates, though they will be low compared to the 1970s and ‘80s.
There is still the danger of the unknown. No one predicted the oil shock of 1973, which is why bankers and politicians floundered in trying to deal with it. No one expected the pandemic either, or the staggering deficits that governments incurred to fight it.
“Economists lack their usual tools, which is to look back at the last five times something happened,” said Avery Shenfeld, chief economist at CIBC World Markets. But there hasn’t been a pandemic in a hundred years. “So there really isn’t an analogy. There is no one who can be entirely confident about how the economy will heal.”
Just another reason why, as 2022 approaches, you’d be wise to get your house in order.
Our Morning Update and Evening Update newsletters are written by Globe editors, giving you a concise summary of the day’s most important headlines. Sign up today.