To Judge Inflation, Think of the Pandemic as a War
To Judge Inflation, Think of the Pandemic as a War
The jump in US consumer prices as the economy began reopening this spring — they rose 4.2% over the 12 months ending in April — has prompted a lot of historical comparisons to the bad old inflationary days of the 1970s.
If we’re going to do historical comparisons, though, why stop at the 1970s? The Bureau of Labor Statistics has monthly consumer price index numbers going back to January 1913, allowing us to calculate 12-month inflation rates from January 1914 onward. That’s just in time to catch the biggest inflation wave in the series, with consumer prices more than doubling from 1915 to 1920 and the 12-month price increase peaking at 23.7% in June 1920.
One can find even bigger annual increases in the consumer-price estimates going back to 1774 that have been assembled by economic historians Laurence H. Officer and Samuel H. Williamson at MeasuringWorth. Annual inflation was 29.8% in 1778, during the Revolution, and 24.8% in 1863 and 25.1% in 1864, during the Civil War.
Major wars tend to be inflationary, as military spending creates a big new source of demand and governments print money to finance it. There were also price spikes in the aftermath of World Wars I and II as the economy shifted back from war footing to peacetime pursuits.
In the US, these wartime-and-after inflations have all been short-lived. In the 18th and 19th centuries the deflations and depressions that followed even wiped out all the wartime price gains, with consumer prices in the US about the same in 1900 as they were in 1776. That changed with the arrival of the Federal Reserve in 1914, 1 and prices never returned to the pre-war levels of 1914 and 1941. But the high inflation rates didn’t last long either.
That wasn’t true of the double-digit inflation of the 1970s and early 1980s, which also followed an expensive conflict (the Vietnam War) but is usually attributed to a pair of oil crises and a succession of monetary policy errors. “America's Only Peacetime Inflation,” as it has been dubbed, lasted more than a decade and gave way to a long stretch of lower-but-sustained inflation that only really ended with the financial crisis of 2008.
The long inflation of the 1970s and after lives on in the memories of many people still active in public life and financial markets, some of whom freak out on occasion that it’s about to come roaring back. Just because the last such freak-out, around 2010, turned out to be much ado about nothing doesn’t necessarily mean all such worries are wrong now. I do think the discourse might be improved, though, by more awareness of the country’s earlier inflationary episodes, especially the two others since the Federal Reserve was created.
Yes, those were both wartime inflations, but the battle against Covid-19 has been likened to a war and led to war-sized budget deficits. The 1915-1920 inflationary period even featured a global pandemic. So here’s a brief refresher (with apologies to those reading on their mobile phones, for whom the annotations on the following charts may be a bit much).
Prices began rising in late 1915 before the US entered World War I, as European countries bought agricultural commodities and war supplies here and shipped gold to New York to pay for it. The US was on the gold standard then, so more gold in New York meant a growing money supply. US entry into the war in 1917 then brought a form of money creation more familiar to modern readers, with the Federal Reserve lending to banks at below-market rates so they could buy the government’s Liberty bonds. Buying the bonds directly — what is now called quantitative easing — was seen as a step too far. In the UK the Bank of England did it, but hid the fact for decades.
At war’s end in 1918 the leading figure in the early Fed, New York Federal Reserve Bank President Benjamin Strong, wanted to end this subsidy. But Treasury Secretary Carter Glass had one last round of Liberty bonds to sell in April and May 1919, and was concerned even after that about keeping bond prices from dropping. The fledgling Fed wasn’t going to risk bucking the Treasury Secretary, and what ensued was, in the words of the Fed’s subsequent annual report, “a year marked by industrial unrest, by economic confusion, by reduced production, increased domestic consumption, high prices, and unprecedented extravagance.”
It’s not clear to me how much of this was due to monetary policy and how much to other factors such as the end of wartime price controls and the shift from military to consumer spending — not to mention the deadliest pandemic in world history, which was at its worst in the US in autumn 1918. In their classic “A Monetary History of the United States, 1867-1960,” which has informed all subsequent discussion of the episode (including this one), Milton Friedman and Anna Schwartz gave all the attention to the Fed. But contemporary accounts also emphasized short-sighted cutbacks in industrial production right after the war, increased demand from overseas, profiteering, speculation and a spirit of excess that resulted in, as the New York Times disapprovingly reported in August 1919, Louisiana lumberjacks “buying $3,000 autos, silk shirts for $10 and $12, and neckties for $5.” More recently, some economists have concluded that the pandemic was inflationary, in part for the awful reason that it removed so many people in their 20s and 30s from the workforce and thus boosted wages for the survivors.
By the time Glass finally lifted his objection to Fed interest-rate increases at the end of 1919, Strong had concluded that the time for them had passed. But after he took a leave of absence to rest and combat a case of tuberculosis, his Fed colleagues quickly hiked the discount rates charged to banks to 7% from 4.6%. Sharp deflation — prices fell 15.8% in the 12 months ending June 1921 — and an economic depression followed. This depression didn’t last long, and a few years ago market pundit James Grant wrote a book about it lauding the laissez-faire response of President Warren Harding (who took office in March 1921) and other officials. But the bigger lesson seems to be that it was probably unnecessary to begin with.
A similar depression was widely expected after World War II, given both the experience after World War I and the weak state of the economy in the 1930s. But while demobilization brought a sharp drop in gross domestic product at war’s end, unemployment didn’t rise much. Inflation did rise, a lot, as price controls more comprehensive than those of the previous world war finally expired in June 1946. But the explosion was (1) short-lived, (2) to some extent just involved official recognition of price increases that had already been effected under the table and (3) did not seem to leave a lasting impression. My dad, who remembers a lot of things about the years 1946 through 1948 — finishing grad school, getting a job, meeting my mom playing softball in Central Park, marrying her — says he has no recollection of an inflation wave.
Federal Reserve policy was again dictated during and after the war by a Treasury Department focused on selling and maintaining the value of the bonds it used to finance the war effort. In 1942 the Fed announced that it would buy and sell three-month Treasuries so as to keep the rate fixed at 0.375%, and more quietly agreed to buy enough longer-term government securities to keep rates from rising above 0.875% on the one-year, 2% on the 10-year and 2.5% on the 25-year.
In July 1947 the Fed began gradually easing away from the rate targets on shorter-term debt, but under pressure from Treasury Secretary John Snyder and President Harry Truman it kept longer-term rates capped. Spiraling inflation as US involvement in the Korean War escalated finally brought a Fed revolt in early 1951, leading to the Treasury-Fed Accord of March 1951 and the modern more-or-less independent central bank. The ensuing rate increases were modest, though, as the Fed successfully engineered the first soft landing of its new era.
The current inflation episode is so far a tiny blip relative to those related above, but there are echoes in this spring’s price hikes of past post-war bottlenecks and shortages, such as the 10% increase in used-car and -truck prices in April caused by production difficulties at automakers and the sudden need of rental-car companies for lots more vehicles. There’s also a somewhat less awful version of the 1918 pandemic’s labor-market effects. Covid-19 hasn’t killed a lot of prime-age workers — less than 8% of its victims in the US have been under 55 — but it has apparently convinced a lot of older Americans to leave the labor force and some others to reconsider their careers.
These all feel like one-time effects that shouldn’t result in continuing inflation, unless Washington bungles things. Will it? The Federal Reserve is still buying bonds while signaling that it won’t talk about pulling back until the economy is much stronger, an approach with some similarities to its delayed and gradual tightening after World War II. Current fiscal policy, on the other hand, bears few similarities to what happened after the world wars, when big federal budget deficits were followed quickly by surpluses.
The federal deficit for the 2020 fiscal year, which ended last Sept. 30, was 14.9% of gross domestic product, similar to the deficits of World War I and about half the size of the biggest deficit of World War II. The Congressional Budget Office is forecasting that deficits will shrink a lot over the next couple of years, but not drop below a still-pretty-big 3.5% of GDP for the foreseeable future — and in the proposed budget unveiled Friday by President Joe Biden they never fall below 4.2%. Does that pose an inflation danger? Outside of wartime, the link between deficits and inflation in the US has been tenuous. The big deficits of the 1980s came after inflation had begun its retreat, and the even-bigger ones of 2009 through 2012 were followed by hardly any inflation at all.
In other words, there are lots of somewhat reassuring historical parallels one can look to these days. There’s also the 1970s. Take your pick.