Inflation: Learning the Proper Lessons From History

The resurgence of inflation in the United States has roused political concern and stirred the Federal Reserve to pivot from patience to seemingly urgent action. Higher inflation has also led to another resurgence: an interest in price controls and a desire to better understand the relationship between inflation and full employment. The push for price controls, while finding favor with a few journalists and politicians, misinterprets economic and political history. However, the new-found interest in the long-term relationship between inflation and full employment, as embodied in the Federal Reserve’s “dual mandate” of stable prices and maximum employment, is certainly well placed. 

Price Controls: The Wrong Lesson

The idea that inflation can be tamed by presidential power rests on the notion that inflation is not a purely monetary phenomenon. As Princeton University’s Meg Jacobs writes in a recent New York Times opinion piece: “Inflation doesn’t rise and ebb just because of monetary policy. It’s largely the result of choices businesses make.” The argument then turns to the history of wage and price controls during the Second World War and the presidency of Richard Nixon as evidence that administrative control of prices can work.  

However, to point to these two examples as evidence that the United States should attempt to impose price controls today is to misinterpret history. One of the most experienced participants in the wartime price control efforts, John Kenneth Galbraith, attributed their success to three things. First, major parts of the economy in the 1940s were controlled by a few large industrial conglomerates and a few large unions—all eager to be seen supporting the war effort and therefore relatively easy to control through administrative tools. Second, the excess capacity for both manufacturing resources and labor that resulted from the Great Depression (and the large influx of women into the labor force) permitted supply to increase greatly without pressing on administratively determined price ceilings. Finally, the public was willing to forgo consumer goods to support the war effort and save for future consumption that was expected once peace returned; shortages that resulted from price controls were accepted as part of the war effort. None of these conditions exist today. 

If the success of the World War II price controls can be attributed to unique circumstances during those years, the most complete technical analysis of wage and price controls undertaken during the Nixon administration concludes that those controls failed. Research by economists at the Federal Reserve Bank of Minneapolis that was published in 1978 concluded that the Nixon wage and price controls held down prices temporarily, but also held down production. Once the controls ended, prices and production both moved quickly to catch up; they rose faster than they would have had controls not been imposed. Importantly, prices ended up higher than they otherwise would have, and real wages (i.e., wages adjusted for inflation) ultimately were lower than they otherwise would have been.  

Of course, should price increases be linked to monopolistic practices as those practices have been historically defined, the relevant antitrust authorities will have to take action.    

Full Employment and Price Stability Are Not Conflicting Goals

While the renewed interest in wage and price controls is misplaced, the growing desire to understand the complex relationship between inflation and long-term full employment provides an opportunity for a helpful history lesson. In his most recent press conference, Federal Reserve Chairman Jerome Powell suggested that high inflation is a “big threat” to full employment. To many observers, who are perhaps unaware of the history of the Fed’s dual mandate, this was a novel argument and inverted logic.  

Some observers believe that the traditional logic is that rate hikes prevent full employment. However, for much of the Fed’s history, and certainly after it was given its dual mandate by Congress in 1977, the Fed has expressed the perspective that a long expansion is required to get back to full employment, and that rampant inflation will force it to take severe action that could cut short such an expansion. Hence, the Fed has traditionally held that there is no conflict between the two components of its dual mandate—and indeed, that price stability is a prerequisite for achieving full employment. 

Much of this thinking in central bank circles is clearly informed by the history of Paul Volcker’s tenure as Fed chair in the 1980s. Chairman Volcker was forced to raise rates dramatically to kill inflation, but in doing so put the U.S. economy into a deep recession. Central bankers ever since have recognized that they want to avoid such an unpleasant but necessary use of monetary policy. Chairman Powell, in expressing the thought that high inflation is inconsistent with full employment, was not breaking new ground in central bank theory, but rather expressing an orthodox view. It is true, however, that this orthodoxy has not been part of the discourse during most of the past several decades, when inflation was surprisingly low globally and Japan suffered from long stretches of mild deflation. 

Importantly, central bank orthodoxy has long held that lower-income individuals are probably the most harmed by high and uncertain inflation. The past year has also forced central bankers to once again face that reality. Indeed, some reports indicate that Fed policymakers pivoted from patience to action when they realized that inflation has severe consequences for low- and moderate-income families in their own communities.

Learning the Right Lessons

The current bout of high inflation has brought these two elements of economic history back to the fore, and it is important to draw the proper lessons. A return to wage and price controls, while alluring, should be avoided as a wrong one. 

On the other hand, viewing price stability as consistent with achieving full employment was a lesson from history that central bankers could ignore for many decades when inflation was unusually low. But with price levels rising sharply, it has now returned to the fore. Policymakers should strive to bring resurgent inflation under control using well-calibrated interest rate increases to avoid reversing the growth that the global economy has enjoyed over the past year.