A Field Guide to Inflation: Lessons from the 1970s, Vol. 1

Economists are divided on the threat from a revival of inflation -- rising prices caused by the enormous stimulus being force-fed to the U.S. economy. Some are more worried about deflation and call for more stimulus in a hurry; others want to stop the stimulus before it creates its own bubble. (See a MoneyWatch Blog War between economists Brad DeLong and Tyler Cowen over the potential consequences of the stimulus package.)

On where inflation will go, no one knows, really: we're just a few months in to the stimulus programs, and don't yet have a reading on the primary goal of turning the economy around, much less the secondary effects of inflation. But personally, I'm on the side of the inflation worriers, and I figure it's worth discussing so we can recognize inflation if and when it comes along.

The longest sustained high inflation in the U.S. economy prevailed from 1973 through 1983. It went through two cycles, the first peaking at 12 percent at the end of 1974, the second topping out near 15 percent in April 1980.

These numbers seem incredible today - inflation fell below four percent in 1991, and except for a few months stayed low until everything started to unravel in 2008. The graph below plots the year-over-year changes in the overall U.S. consumer price index during that awful time.

The direct effect of inflation? That we all know: it erodes the purchasing power of assets and incomes. Imagine being on a fixed pension from 1973 to 1983. By the time inflation settled down, the general price level had risen two and a half times: for a basket of goods costing $40 in 1973, you had to fork over $100 in 1983. That's an average inflation rate of about eight percent per year for 11 years.

The indirect effects are just as harmful, for the damage they inflict on people's economic expectations. When inflation is low and stable, consumers and businesses can make long-term plans that have a reasonable chance of playing out.

But rising and unstable inflation creates uncertainty for everyone, requiring a lot of guesswork on when to sign a lease, buy inventory or hire workers, where to set prices and wages, and whether and when to buy a house or a car. Or when inflation is running at 15 percent, when to buy an extra pound of coffee.

Lenders have to account for inflation too, and add a premium to the interest rates they charge, to compensate for the loss in value of the principal over time. Therefore inflation increases the all-in costs of buying a house, or car, or anything else bought on credit.

The two graphs below illustrate inflation's effects on asset values and expectations -- the impact of the uncertainty that prevailed from 1973 to 1983.

From 1973 to 1983, the Standard & Poor's 500 stock index rose pretty steadily, but the annual rate of return was just eight percent - the same as inflation. So stocks held their real value, after inflation, but did not make any progress for 10 years. The graph also illustrates investors' greater appetite for stocks after 1982, when inflation started coming down and the economy started to recover.

Pay careful attention to the graph on inflation versus interest rates. During the first surge of inflation in the 1970s, inflation peaked at over 12 percent, but T-bill rates never went above nine percent.

Investors factored too little future inflation into their forecasts: inflation in the U.S. had been above 10 percent between 1910 and 1920, and in a few episodes during WWII, but not above 10 percent for many years. Twelve percent inflation must have seemed like science fiction.

In the second surge, however, investors decided they wouldn't be fooled again, and demanded interest rates that kept up with the CPI, and for good measure, stayed high for several years after. Imagine that -- U.S. government-guaranteed T-bills yielding over 15 percent!

But the inflation premium is telegraphed into every other interest rate. For instance, at lunch yesterday my friend Brett told me that when he bought his first house, in 1981, the seller financed the mortgage, so he was able to get a great deal - 13 percent. (For reference, T-bills are under one percent today, and home mortgages are around five percent.)

That's a review of the corrosive effects of the unusual inflation of the 1970s. In a post tomorrow I'll look at the causes of those high prices, and how they relate to 2009's recessionary and highly-stimulated economy.