Inflation: as bad as the 1970s? At least some think it is

Consumer prices rose 8.6 per cent in the US last month from a year earlier. Inflation has risen to its highest level in four decades, raising the cost of airfare, hotels, vehicles, gas, and food. Picture: Getty

At least it’s not as bad as in the 1970s.

That’s one glass half full approach to assessing the inflationary burst spreading painfully throughout the world, foreshadowing potentially economy-crushing rates of interest.

governments, central banks and an army of experts caught embarrassingly off-guard by rising inflation over the last 12 months – which they said would be transitory – could reassure themselves at least that the challenge of reducing inflation wouldn’t be as great as in the wake of the two 1970s oil shocks.

But is that even true?

One of the world’s best-known economists, Larry Summers, former president of Harvard University and US Treasury secretary under Bill Clinton, thinks not.

“The current inflation regime is closer to that of the late 1970s than it may at first appear,” he and co-authors from the International Monetary Fund have concluded in a new research paper, which makes grim reading for central banks everywhere as they ponder how much and how soon to lift their benchmark rates in coming months.

US inflation rose to a fresh record of 8.6 per cent in May, the highest since December 1981, once again defying expectations that the price increases that began with energy and spread to almost all goods and services would begin to level off.

They haven’t and it turns out inflation is almost as high as it was in the early and late 1970s, when central banks ultimately resorted to painful interest rate shock therapy to squeeze inflation out of their economies.

Economist Larry Summers. Picture: David Paul Morris/Bloomberg

The 14.8 per cent peak in CPI inflation March 1980 would be 11.4 using the current methodology for calculating inflation, according to Summers et al, and the early 1970s peak of 12.3 per cent would be 9.1 per cent – only a couple of percentage points more than the current level.

The way the US government calculated inflation changed radically in 1983, when house prices and the interest rates on home loans were removed from the consumer price index, to be replaced by actual and estimated rents.

The purchase of a home is both a form of investment and consumption; economists wanted to exclude the investment component to obtain a cleaner measure of consumer price inflation.

The average inflation rate from 1949 to 1983 would 0.4 percentage points lower when accounting for the change, Summers found.

The US economy unexpectedly shrank in the first three months of the year. The Atlanta Federal Reserve Bank, which provides a week by week forecast of economic growth, slashed its best guess for the second quarter to 0.9 per cent at an annual rate – that is, barely anything over the three months.

The prospect of low growth, high inflation and interest rates will invite comparison with another experience from the 1970s: stagflation.

The realisation inflation is almost as bad as it was in the 1970s wasn’t Summers’ only sobering conclusion: interest rate increases weren’t as effective in snuffing inflation out as central banks typically believe.

“The responsiveness of the CPI to monetary policy was considerably lower during the 1960s and 1970s than the official CPI statistics suggest,” the new paper reads.

The then Federal Reserve chairman, Paul Volcker, lifted interest rates above 20 per cent in the early 1980s in a bid to slash inflation. It worked, but at great cost, tipping the US into recession a few months later.

It turns out the impact of Volcker’s tough medicine was a reduction in inflation of five percentage points, using today’s CPI calculation methodology, not the 11 it would seem using the official CPI series.

“The disinflation that needs to be achieved now is large by historical standards,” Summers and his co-authors concluded, noting the prevailing gap between inflation of almost 9 per cent and the Fed’s inflation target of 2 per cent.

The US Federal Reserve will almost certainly lift the federal funds rate by another 0.5 percentage points on Wednesday, at the end of its two-day meeting, bringing the benchmark rate to 1.5 per cent.

Further increases in interest rates are expected to leave the benchmark rate around 3.5 per cent by the end of the year. Will that be enough to reduce inflation? Who knows.

What’s more certain is the greater impact higher rates will have on the heavily indebted US economy, which already shrank unexpectedly in the first three months of the year, before the Fed even began to lift interest rates, compared with the 1980s.

Even small increases in interest rates can have a large impact on borrowers when loan values are large.

US government debt as a share of GDP has tripled to around 120 per cent since the early 1980s.

For American households, the burden has increased from around 50 per cent to 80 per cent.

Those handful of expected 0.5 percentage point increases have the potential to sap spending power and consumer confidence, which fell to the lowest level in decades last week, according to a closely watched survey released by the University of Michigan.