A customer shops at a market in the Brooklyn borough of New York on May 12. US consumer prices rose 0.8 per cent in April from a month earlier, with the annual rate jumping to 4.2 per cent, the highest since September 2008. Photo: Xinhua
Stephen Roach
Stephen Roach

How the US Fed’s reassurances on inflation fears are triggering a 1970s flashback

  • Now as then, the Fed sees recent increases in the prices of food and other essential goods as transitory, believing they will stabilise with post-pandemic normalisation
  • But the biggest parallel may be another policy blunder – as before, the Fed is keeping real interest rates depressed, which in the 1970s only fuelled inflation
I have long been haunted by the inflation of the 1970s. Fifty years ago, I was witness to the birth of the “ Great Inflation” as a Fed insider. That left me with the recurring nightmares of a financial post-traumatic stress disorder. The bad dreams are back.

They centre on the Fed’s legendary chairman at the time, Arthur F. Burns, who brought a unique perspective to the US central bank as an expert on the business cycle. Yet he lacked an analytical framework to assess the interplay between the real economy and inflation, and how that relationship was connected to monetary policy.

As a data junkie, he was prone to segment the problems he faced as a policymaker, especially the emergence of what would soon become the Great Inflation. He believed price trends were, like business cycles, heavily influenced by idiosyncratic, or exogenous, factors – “noise” that had nothing to do with monetary policy.

This was a blunder of epic proportions. When US oil prices quadrupled following the Opec oil embargo in 1973, Burns argued that, since this had nothing to do with monetary policy, the Fed should exclude oil and energy-related products (such as home heating oil and electricity) from the consumer price index.

Staff protested, arguing that it made no sense to ignore such important items, especially because they had a weight of over 11 per cent in the consumer price index. Burns was adamant.

Oil ministers of six Persian Gulf countries and representatives of Western nations meet in Vienna, Austria, on October 8, 1973, to negotiate prices. Opec imposed an oil embargo later that month aimed at undermining support for Israel in the wake of the Yom Kippur war. Photo: AP

Then came surging food prices, which Burns surmised in 1973 were traceable to unusual weather – specifically, an El Niño event that had decimated Peruvian anchovies in 1972. He insisted that this was the source of rising fertiliser and feedstock prices, in turn driving up beef, poultry, and pork prices. Like good soldiers, we gulped and followed his order to take food – which had a weight of 25 per cent – out of the CPI.

We didn’t know it at the time, but we had just created the first version of what is now fondly known as the core inflation rate – that purified portion of the CPI that purportedly is free of the volatile “special factors” of food and energy, where gyrations were traceable to distant wars and weather. Burns was pleased. Monetary policy needed to focus on more stable underlying inflation trends, he argued.

It was a fair point – to a point; unfortunately, Burns didn’t stop there. Over the next few years, he periodically uncovered similar idiosyncratic developments affecting the prices of mobile homes, used cars, children’s toys, even women’s jewellery; he also raised questions about home ownership costs, which accounted for another 16 per cent of the CPI.

US Federal Reserve walking fine line with approach to rising inflation

By the time Burns was done, only about 35 per cent of the CPI was left – and it was rising at a double-digit rate. Only at that point, in 1975, did Burns concede – far too late – that the US had an inflation problem. The painful lesson: ignore so-called transitory factors at great peril.

Fast-forward to today. Evoking an eerie sense of déjà vu, the Fed is insisting that recent increases in the prices of food, construction materials, used cars, personal health products, petrol, car rentals, and appliances reflect transitory factors that will quickly fade with post-pandemic normalisation. Scattered labour shortages and surging home prices are supposedly also transitory. Sound familiar?
Federal Reserve chair Jerome Powell testifies before a House Financial Services Committee hearing on December 2 last year. The US economy will temporarily see “a little higher” inflation this year, Powell said, but the Fed is committed to limiting any overshoot. Photo: Pool via Reuters

There are many more lessons from the 1970s that shed light on today’s cavalier dismissal of inflation risk. When the Fed finally tried to tackle the Great Inflation, it fixated on unit labour costs – rising wages accompanied by sagging productivity.

Wages appear to be largely in check; unionised labour, which in the 1970s had sparked a vicious wage-price spiral, has been neutralised by global competition. But that doesn’t rule out a very different form of global cost-push inflation – namely, the confluence of supply-chain congestion (think semiconductors) and protectionist clamouring to reshore production.


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But the biggest parallel may be another policy blunder. The Fed poured fuel on the Great Inflation by allowing real interest rates to plunge into negative territory in the 1970s. Today, the federal funds rate is currently more than 2.5 percentage points below the inflation rate.

Now, add open-ended quantitative easing and the largest fiscal stimulus in post-World War II history. All of this is occurring precisely when a post-pandemic boom is absorbing slack capacity at an unprecedented rate. This policy gambit is in a league of its own.

Inflation is here, but the market and the Fed have yet to react

For my money, today’s Fed waxes far too confidently about well-anchored inflation expectations. It also preaches the new gospel of “ average inflation targeting”, convinced that it can condone above-target inflation for an unspecified period to compensate for years of coming in below target.

No, this isn’t the 1970s, but there are haunting similarities that bear watching. Timothy Leary, one of the more memorable gurus of the Age of Aquarius, purportedly said, “If you remember the 1960s, you weren’t there.” That doesn’t apply to the 1970s. Sleepless nights and vivid flashbacks, complete with visions of a pipe-smoking Burns – it’s almost like being there again, but without the great music.

Stephen S. Roach, a faculty member at Yale University and former chairman of Morgan Stanley Asia, is the author of Unbalanced: The Codependency of America and China. Copyright: Project Syndicate

This article appeared in the South China Morning Post print edition as: Fed’s reassurances on inflation are triggering 1970s flashback