The Relay of U.S. Stagflation

  The persistently high inflation experienced by the United States in the post-pandemic era recalls the “Great Stagflation” of the mid-1960s to the late 1970s. “Will it happen again?” became the market’s concern. If the inflation of 2020-2022 is just a rehearsal of another era of “Great Stagflation”, both equity and fixed income assets will face a long-term test, while real assets, including commodities, will prevail. Within equity assets, growth will underperform value and defensive sectors. So, the first question that needs to be answered is, how did the “Great Stagflation” happen?
  For too long, we have overemphasized the shocks of the two oil crises of 1973 and 1979, and underestimated the role of politics-ideology, economics-ideology, monetary policy and geopolitics.
  At the political-ideological level, during the “Great Stagflation” period, the trend of American progressivism and populism was on the rise, which was concentrated in Johnson’s “Great Society” concept, and the post-epidemic era was the “Biden New Deal” – the return of progressivism;
  In terms of economics and ideology, the former stage is guided by the empirical relationship between Keynesian economics and the “Phillips curve”, stabilizing growth and ensuring employment are the top priorities, and inflation tolerance is high. In the latter stage, Modern Monetary Theory ( MMT) takes Keynesian economics to the extreme, and its proposition on “monetization of fiscal deficits” has laid the theoretical foundation for the policy propositions of progressives in the US Democratic Party (such as Sanders and Warren);
  Monetary Policy Level, 1970s The 1990s are considered to be the “lost decade” of the Federal Reserve. The independence of monetary policy has been completely lost. The chairman of the Federal Reserve has never recognized that monetary policy is the cause of inflation, and also denied the effectiveness of monetary policy in fighting inflation. In the post-pandemic era, the credibility of the Federal Reserve is being challenged due to runaway inflation, and there are many critics.
  Geopolitically, the “Great Stagflation” started in 1965, marked by the escalation of the Vietnam War. At present, the prospect of the Russian-Ukrainian conflict is still unclear, but the risk of geopolitical conflict may be a logical main line in the 2020s, and the United States will also play an important role in it.
  In general, although inflation and “great stagflation” in the post-epidemic era are mainly manifested as “cost-push inflation”, the boost of demand-side policies cannot be ignored either. This article mainly analyzes the formation of “Great Stagflation” to provide reference for the current and future inflation situation.
The Vietnam War and the Johnson-Martin Era

  After President Kennedy was assassinated in November 1963, Johnson took over as president, and low-cost financing for the Vietnam War and the idea of ​​the Great Society became a White House priority.
  Political demands coincide with the mainstream trend of thought in economics. At that time, Keynesianism had already occupied the mainstream economic position in the United States. Keynesians serve on important economic branches such as the President’s Council of Economic Advisers (CEA), the Treasury Department, and the Federal Reserve. Taking the classic “Phillips curve” as the guideline, they believe that when the labor market has not yet achieved full employment, loose monetary policy will not lead to inflation, and tightening monetary policy will only increase unemployment and will not reduce inflation. Policies are coordinated with fiscal policies to keep the economic growth rate above 4% and the unemployment rate below 4.5%.
  Johnson’s top priority in administration was to push through legislation on the tax cuts proposed by Kennedy in 1963. The bill was passed by Congress in 1964, signaling an agreement between the government and Congress to keep unemployment low. This was the start of Martin’s nightmare, as the bill required the Fed to keep interest rates unchanged so as not to offset the effect of the tax cuts and also to create conditions for later government bond issuance.
  In the mid-1960s, as the Vietnam War escalated, inflationary pressures became increasingly prominent with the increase in overseas defense spending and the credit inflation created by the government’s artificially low interest rates (Figure 1). Beginning in early 1966, the year-on-year growth rate of the U.S. consumer price index (CPI) accelerated after breaking through 2%, reaching a periodical high of 3.8% in October. As the economy weakened, the upward momentum in inflation moderated. In November 1967, inflation turned up and crossed 6% by the end of 1969.
  Another context for inflation is the minimum wage bill. Minimum wage legislation is a legacy of Roosevelt’s New Deal. In 1938, the Fair Labor Standards Act (FLSA) was the first legislation to introduce a federal minimum wage ($0.25) covering 54 percent of the U.S. workforce in manufacturing, transportation and communications, wholesale trade, finance, and real estate. Since then, the nominal minimum wage has been gradually increased and the coverage of the industry has continued to expand. Johnson’s 1966 amendments to the Labor Act extended the federal minimum wage to the agriculture, nursing home, laundry, hotel, restaurant, school, and hospital industries. In 1967, these industries employed approximately 8 million workers, representing 21 percent of the U.S. workforce, covering nearly one-third of the black and 18 percent white workforce (Derenoncourt et al., 2020). In late 1968, the labor market tightened and the unemployment rate fell to 3.4%, creating a wage-price spiral in the late 1960s.
  In the last five years of his term, Martin’s political and public opinion pressures increased significantly. The principles of the 1951 agreement were broken step by step, and the decision to tighten monetary policy was repeatedly opposed by the president and Congress. The Fed’s independence was lost. Under the guidance of the “running against the wind” rule, Martin hopes to raise interest rates ahead of schedule to prevent inflation, but has been unanimously opposed by the government and Congress. Even within the Fed, Martin has struggled to win over supporters. For example, at the October 1965 FOMC meeting, Martin’s proposal to raise interest rates did not receive a majority. From 1966 to 1967, the Federal Reserve delayed raising interest rates several times (Hazel, 2017). The several rate hikes that have been achieved have been met with fierce criticism. For example, the rate hike in August 1966 was protested by the real estate industry.
  Johnson’s team of economic advisers has repeatedly proposed tax increases to curb inflation but failed. Treasury Secretary Fowler is also a staunch opponent. The idea of ​​Martin’s multiple rate hikes has been delayed again and again while waiting for the government to raise taxes. The idea at the time was that tax increases had to be premised on easy monetary policy. With the Vietnam War spending increasing and inflation rising, tax increases had to be on the agenda, only to be delayed by the effects of the economic cycle. The first was in August 1967, when the Johnson government submitted a tax increase proposal. At the same time, in order to ease the selling pressure on the pound, the Federal Reserve once again delayed raising interest rates. The second was on June 28, 1968, when Congress passed the Fiscal Revenue and Expenditure Control Act, which increased the income tax rate by 10 percent. In exchange, Martin lowered the discount rate. At that time, the U.S. inflation rate was over 4.2%, and the unemployment rate was only 3.7%, and the former and the latter were still on an upward and downward trend respectively. At a congressional hearing in February 1969, Martin called the two easings in 1967 and 1968 “mistakes of the last few years.” Daniel Bell attributed the inflation of the second half of the 1960s to “deception” by the Johnson government. Paul Volcker, then an assistant undersecretary of the Treasury, later recalled: “The inability of appropriate austerity policies, then and beyond, to respond to the economic stimulus from Vietnam War spending seemed to be the beginning of an inflationary process that has lagged us for years.”

The Nixon-Burns Era and the First Oil Crisis

  In 1968, Nixon was elected president, opening a new round of experiments to curb inflation. Based on the experience of the Phillips curve, Nixon believed that only a slight increase in unemployment to the 4% level would be required to achieve price stability. However, by the end of 1970, the unemployment rate had risen to 6.1%, and the year-on-year CPI growth rate had only dropped from a high of 6.2% in December 1969 to 5.6%. The failure of the “moderate suppression” experiment seems to confirm the “cost-push inflation” hypothesis – the Phillips curve has shifted upward to the right. Samuelson and Solow wrote as early as 1960: “If modest demand restraint does not, or only marginally, stems the rise in costs and prices, mass unemployment will be unavoidable until the end of the price rise. And the cost-push hypothesis would thus be confirmed.” At this point, the cost of controlling inflation by creating unemployment would be extremely high. They suggested using “direct price and wage controls” to “reduce the conflict between full employment and price stability”. So, unlike the Johnson administration’s tax hike and anti-inflation plan, Nixon’s plan was more direct: price and wage controls. In hindsight, this was another “cheating” on the Fed.
  Burns succeeded Martin as Fed chairman in 1970. Burns, although not a Keynesian, agreed with Keynes on the effectiveness of fiscal and monetary policy. Although he was Friedman’s teacher, he did not agree with Friedman’s interpretation of inflation as a monetary phenomenon. Burns believes that the main goal of monetary policy is full employment, and fiscal and income policies (price and wage controls) should be relied on to manage aggregate demand to stabilize prices. Empirically, Burns agrees with the substitution relationship between inflation and unemployment revealed by the “Phillips curve”. The prevailing view within the Federal Open Market Committee (FOMC) also holds that as long as the output gap is negative, or the unemployment rate is above 4.5%, easy monetary policy will not be the cause of inflation.
  Shortly after Burns took office, the Fed began cutting interest rates and increasing the money supply. Burns hopes to use loose monetary policy to support employment in exchange for the government’s control of wages-prices to achieve stable prices. In August 1971, while closing the golden window, Nixon implemented wage-price controls, an important part of the “New Economic Policy”. The first stage is a 90-day wage-price freeze, and the second stage is the establishment of a cost of living committee, a price committee and a remuneration committee. The annual price increase set by the Price Committee is 2.5%. The pay committee has set an annual wage increase of 5.5%, with a 3% gap considered to be labor productivity growth. Price-wage restrictions are extensive and strictly enforced. With prices starting to fall, Burns no longer has to worry about runaway inflation.
Figure 1: The era of the “Great Stagflation” in the United States (1965-1982)

Note: The M1 growth rate data is above the timeline, which is equivalent to a two-year lag. Source: Federal Reserve, WIND, Orient Securities Wealth Research Center. Graphics: Yan Bin

  Wage-price controls were “appearing to be successful”, neglecting the fact that the decline in money supply growth had begun as early as 1969, due to the tightening of monetary policy during the last two years of Martin’s term. At that time, the Fed’s target range for M1 growth was 4.5%-6.5%. From November 1969 to August 1970, the M1 growth rate has been running below 4.5%, and the low point was only 2.86% (March 1970). Since there is a time lag of about 12 to 18 months in the transmission of money quantity to prices, the anti-inflation in 1970-1972 should not be attributed solely to wage-price controls.
  The weaker-than-expected growth in M1 has strained relations between Burns and the White House. After the defeat in the congressional elections in the fall of 1970, the Nixon administration looked more eagerly to the expansion of monetary policy. Beginning in 1970, the FOMC steadily lowered interest rates. By the end of 1972, the discount rate and the federal funds rate had dropped by 1.5 and 6 percentage points, respectively, and the growth rates of M1 and M2 had rebounded to 8.4 percent and 12.8 percent, respectively, the peaks since the 1960s.
  In early 1973, inflation made a comeback. Burns remains opposed to raising interest rates, after all, inflation is just over 3%. Due to the recovery of the economy, price controls not only failed to control prices, but created shortages and pushed prices up further. Burns also extended price controls to interest rates. While the Fed raised the federal funds rate, Burns blocked banks from raising prime lending rates. Companies have shifted from the commercial paper market to bank loans, leading to a sharp increase in credit growth. Before the outbreak of the oil crisis in October 1973, the US CPI growth rate had risen to 7.4%. In April 1974, Congress allowed the price control bill to expire, and the impact of the oil crisis was superimposed, and the inflation rate exceeded 12% by the end of the year.
  After Watergate, Nixon was forced to resign. On August 9, 1974, Ford took over as president. In the congressional midterm elections, the Republican Party lost 48 seats in the House of Representatives and 5 seats in the Senate, and the bipartisan struggle became fierce. During Ford’s administration, U.S. inflation was still accelerating, and fighting inflation became a top priority. Given that price controls have led to supply-side shortages, Ford no longer supports wage and price control policies. Although the Fed has also shifted the focus of monetary policy to inflation, Burns still believes that the fiscal deficit is the root cause. Greenspan, who was then chairman of the White House Council of Economic Advisers (CEA), also believed that the Fed purchased a large amount of government bonds to prevent a credit crunch, and the monetization of fiscal deficits was the source of inflation. In fact, apart from the significant increase in government bonds held by repurchase agreements, the Fed has not significantly expanded its balance sheet. Reserves have also been rising steadily following a 1960s trend. The expansion of credit mainly comes from the currency creation of commercial banks.
The Carter-Burns Era and the Second Oil Crisis

  After 1973, the Fed’s monetary policy began to tighten. The discount rate rose to a high of 8% in May 1974. In early 1975, the growth rate of money supply (M1) dropped to 3.5%. The year-on-year CPI growth rate began to decline after reaching a high of 11.7% in February 1975, and dropped to 4.3% by the end of 1976. The unemployment rate peaked slightly behind the monthly CPI, reaching a high of 8.8% in June 1975. Jimmy Carter won the 1976 presidential election. That year, the modest economic recovery did not bring about a significant drop in the unemployment rate, which fluctuated around 7.5% throughout the year and was still at 7.8% at the end of the year. Carter’s economic brains were “uniquely Keynesian” like Larry Klein. “The view that monetary policy is responsible for managing aggregate demand to maintain low unemployment peaks.” This is also the consensus of FOMC members. Radicalism is back, and history is repeating itself.
  Burns’s concept has not changed, he still does not recognize the relationship between the quantity of money and prices, and he still stubbornly tries to achieve the goal of price stability by influencing the Carter administration’s fiscal and revenue policies. In 1977, the year-on-year CPI growth rate remained at around 6%. The unemployment rate, although beginning to fall, remained high at 6.5% by the end of the year. The Fed believes that there is still excess capacity in the economy, and inflation is mainly caused by supply-side reasons. At the FOMC’s regular meeting in January 1977, Burns pointed out that “any action by the Federal Reserve aimed at lowering monetary growth would be considered to add to the chaos of the fiscal package.” At the July regular meeting, Burns planned to raise the policy rate from 5.375% to 5.5%, but only three members supported it and the vote failed.

  Whether M1 growth should be reined in is another topic of debate at the FOMC. Since its introduction in March 1975, the target range for the growth rate of monetary aggregates has been lowered, but the actual growth rate has often exceeded the upper limit of the target range. The M1 growth rate is an intermediate target. When the M1 growth rate is too fast, the Fed should raise interest rates. The idea at the time was that lowering the M1 growth rate would require a substantial rate hike, which the economy could not bear. So, until Volcker became Fed chairman in 1979, the Fed did not really implement the M1 target range. It’s just a “soft constraint”. Burns chooses to “good faith neglect”, arguing that economic growth is the last word, not monetary aggregates. Since the end of 1976, the growth rate of M1 has risen above the upper limit of the target range of 6.5%, and again exceeded 8% in September 1977. Inflation in the United States in the late 1970s also had a contribution of loose money, given its lagged effect on inflation (see Figure 1). Hazel believes that the FOMC is actually taking the nominal output level as the intermediate target of monetary policy, with the ultimate goal of eliminating the negative output gap (Hazel, 2017, p.187). Greenspan recalled that Burns’ attack on inflation appeared to be rhetorical, “if you look at what the Fed has done during this period, you can hardly see his anti-inflation attitude.”
  The Full Employment and Balanced Growth Act of 1978 (the Humphrey-Hawkins Act) restated the Federal Reserve’s monetary policy objectives: “The Board of Directors and the Federal Open Market Committee of the Federal Reserve System shall maintain a in order to effectively promote the attainment of the goals of maximum full employment, stable prices and moderate long-term interest rates.” Of both employment and inflation, employment is still more important.
  In February 1978, Miller took over as chairman of the Federal Reserve and fully armed the FOMC into Carter’s supporters. The Fed firmly believes that monetary policy will not trigger inflation as long as the unemployment rate is above 5.5%. Since the second half of 1977, the M1 growth rate has been running above the upper limit of the target range (6.5%), and by the end of 1978, the inflation rate has exceeded 9%. Miller believes strong unions, rising wages and profits in the private sector are to blame. In a memo to Carter in early 1978, then-CEA Chairman Schultz said: “We see no sign that inflation is picking up, nor do we think it has the potential to accelerate within two years.” In 1979, the oil crisis broke out again, and the economy fell into stagflation again. The Fed is still hesitant to tighten monetary policy. In the early 1980s, inflation hit a high of 15%.

  It is a fallacy to use the first oil crisis as the starting point for America’s “Great Stagflation” of the 1970s. The history of the “Great Stagflation” introduced on the Fed’s official website is from 1965 to 1982, beginning with the escalation of the Vietnam War and ending with the Volcker era. The “Great Stagflation” is a “relay race”. Fiscal deficits and monetary easing are the initiators, and the oil crisis is just the last stick. A single oil shock cannot generate sustained inflation (Hunt, 2006). At various stages, the Vietnam War, the Labor Act of 1966, the “Nixon Shock” of 1971, and the wage-price controls of the Nixon era all contributed. What cannot be ignored is the government’s willingness to impose implicit inflation taxes (Hazel, 2017, Chapter XII), as well as the loss of Fed independence and the politicization of monetary policy.
  New York Reserve economist Meulendyke (1998) observed that for much of the 1970s, the FOMC was reluctant to raise the federal funds rate significantly, causing monetary policy to lag price trends. Zelstra, then the head of the International Monetary Fund (IMF), said: “If it weren’t for the fact that countries were keen to over-expand their monetary policies in 1972-1973… OPEC’s price hikes would not have been sustainable.” Because in the US dollar Under the system, the loose monetary policy of the United States will export inflation to the world. After the “Nixon Shock” in August 1971, the effective exchange rate of the US dollar depreciated by 10.35%, which played a role in boosting inflation in the United States (Volcker and Xingtian, 2018, p.206). However, until the end of the 1970s, the “wage-price” spiral theory and the “monetarist” null theory still dominated. It was not until Volcker successfully defeated inflation that people’s perceptions were corrected and Keynesianism fell from the altar.
  The history of the “Great Stagflation” fully illustrates the stubbornness of ideas and the harmfulness of misconceptions. The lesson is that the Fed must adhere to the independence of monetary policy and rebuild the credibility of its policy. Today, half a century later, the Powell-era Fed is retracing the Burns path. “As with stagflation in the 1970s, the Fed is again denying that its own policies are responsible for the recent spike in inflation, although there are good reasons to believe it is. It’s not too late to learn from past mistakes and change course, but the time It is passing quickly.” Looking back a year later, Powell’s “temporary inflation theory” in 2021 has been falsified. Can the current acceleration of interest rate hikes and the shrinking of the balance sheet suppress the inflationary pressure caused by the late contraction? Experience has shown that even a recession and rising unemployment cannot bring inflation down to the policy target range quickly enough if inflation is primarily driven by supply-side causes.

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