And it came to pass that Pharaoh had a dream. And in the dream seven cows, fat and sleek, came up from the Nile. And then seven other cows, wretched and lean, came up from the Nile and ate the seven fat and sleek cows. Then Pharaoh woke up. He fell asleep and dreamed a second time. There growing up on one stalk were seven ears of grain, full and ripe. And then, sprouting up behind them, were seven ears of grain, meager and scorched. And the seven scanty ears of grain swallowed the seven full and ripe ears of grain. Then Pharaoh woke up.
And Pharaoh asked all the Economists in Egypt to interpret his dreams, but all they could say was, “On the one hand, this,” and “On the other hand, that.” At last Pharaoh asked the newly appointed Chief of the Egyptian Federal Reserve for his interpretation. And Joseph said, “The two dreams are one and the same. The seven fat cows and the seven ripe ears of grain are seven years, as are the seven lean cows and the seven shriveled ears of grain. Seven years are coming bringing great plenty to the land of Egypt, but seven years of famine will follow them.” And Joseph said, “We must raise interest rates to prevent the economy from overheating and causing inflation expectations to become unmoored during the seven years of plenty. Then, perhaps we can ease credit conditions during the seven years of famine; that is, as long as inflation expectations remain well-anchored.” And all who heard Joseph wondered and were amazed.
As well they might have been, if manipulating interest rates was actually what Joseph proposed. Instead, Joseph’s solution was fiscal, not monetary. He suggested a special 20% tax during the seven years of plenty to form a reserve against the seven years of famine to come. Conceivably, though, Joseph could have been concerned about inflation. Inflation is the reduction in purchasing power or, equivalently, the loss of value, of a nation’s currency. Inflation becomes a very serious problem, if, over time, the general price level of goods and services increases rapidly and substantially. In a relatively primitive agricultural economy like Pharaoh’s, nearly all income, at least for commoners, went for food. A famine would cause the price of food to rise drastically, meaning that a rise in food costs would be indistinguishable from a general rise in all prices. Genesis emphasizes just how much Joseph’s brothers are willing to pay for their grain when they bring their beloved youngest brother, Benjamin, to be held hostage.
Since biblical times, the dynamics of inflation have become more complicated. This is because modern inflation is a monetary phenomenon, not a natural one. The first known instance of what we would recognize as inflation occurred during the latter days of the Roman Empire, when a succession of corrupt and greedy emperors progressively reduced the silver content of the coinage. The citizenry weren’t fooled and prices just as progressively rose. Similar episodes of politically engineered inflation occurred in Germany after World War I, when the Weimar government debased the currency to avoid paying reparations to the Allies, and in present-day Zimbabwe, where the Mugabe regime has perfected hyperinflation as a means of insuring the loyalty of its supporters.
But inflation isn’t always deliberately manufactured. The United States suffered from steadily more debilitating and rapidly recurring bouts of inflation from the end of World War II until 1981. During this period, the demand for skilled labor often exceeded its supply, and per capita income rose steadily. Organized Labor became a powerful force that could impose its demands on whole industries. I am no Marxist, but if Dialectical Materialism—the theory that imagines history as a pendulum—applied anywhere it was to Organized Labor in the last century. Production workers were brutally exploited in the industrializing societies of the late 19th and early 20th centuries. Exploitation catalyzed strong trade unions that demanded reforms (sometimes to the point of revolution). As time passed and success followed success, Labor was corrupted and its demands became overblown and, finally, self-defeating. The industries, whose prosperity, after all, was the only possible source of satisfying Labor, fell into a decline from which many show no sign of emerging. The power of Organized Labor similarly plunged.
The loss of Organized Labor’s power and influence in the United States was turbo-charged by two concurrent events, increased productivity through technology and the globalization of labor. With goods and many services being produced worldwide, American companies, or at least those not buried in legacy contracts, could source their supply lines far more cheaply abroad than at home. But a funny thing happened on the road to cheaper production: the best of the low-cost producer nations began to get rich. As they got rich, they and their citizens began to demand and acquire more of the world’s goods. And as the demand for those goods began to increase, so did their prices, most notably, the prices of oil and gasoline.
Inflation, recall, is not the increase of a few prices. It is an increase in all prices, so that consumers can’t escape it by switching from, say, oranges to apples when an unseasonal freeze hits Florida and citrus prices rise. But also recall that inflation is a human-made event, and as such, has a strong psychological component. High gas prices, whatever the cause, are frightening in a country as spread out and dependent on the automobile as America. If gasoline is no longer cheap and plentiful, I won’t be able to get to work, and if I can’t get to work, I’ll lose my job, and if I lose my job…When we add to this fear, the fact that no other product in the world is advertised so ubiquitously and so purely by price as gasoline, we begin to grasp the broader implications of rising gasoline prices for inflation and for inflation expectations.
Inflation, being a monetary phenomenon, is the purview of a nation’s Central Bank, in America, the Federal Reserve. Crucially, the Federal Reserve has been specifically charged by Congress with being uniquely and solely responsible for achieving and maintaining price stability. The orthodoxy at the Federal Reserve today is that rising inflation is not only preceded but actually caused by rising inflation expectations. To demonstrate this point, it is necessary, and at the risk of interrupting my train of argument, to quote at some length from a speech given by Charles Plosser, President of the Federal Reserve Bank of Philadelphia on July 22.
“Achieving inflation below 2 percent over the next couple of years depends critically on the public’s inflation expectations remaining well-anchored. That is, households, workers, businesses, investors, financial firms, all must have confidence that the Federal Reserve will not let inflation get out of control, despite the recent persistent upward pressure on headline inflation from energy and other commodity prices.
Why is this so important? Let me highlight the reason by drawing on the experience of the latter half of the 1970s — a period when inflation expectations did, in fact, become unanchored. It is a bit of history we do not wish to repeat. During that time, the public saw inflation rising relentlessly and concluded that the Federal Reserve was unable or unwilling to take the necessary steps to bring it under control.
Fearing that inflation would continue to rise, many suppliers to businesses began putting automatic escalator clauses tied to various measures of inflation into their long-term contracts. Workers, also fearing higher inflation, began demanding higher wages, and labor contracts increasingly contained automatic cost-of-living adjustments, or COLAs. Firms agreed to pay higher wages because they anticipated being able to pass along those higher labor costs by raising the prices of their own products. This led to what some economists call a wage-price spiral.
I want to make clear that the rise in inflation expectations in the 1970s was not caused by a wage-price spiral. That story has things backwards. The wage-price spiral was a consequence of the inflation and the unanchoring of expectations of inflation, not the other way around. And the unanchoring of inflation expectations was caused by the public’s loss of confidence in the Federal Reserve’s resolve to bring inflation back down. The credibility of the Fed’s promise to deliver price stability was lost.”
This is entirely and perversely wrong. It is one thing for Congress to tell the Fed it is responsible for price stability. It is something else altogether for high officials of the Fed to actually believe and boast that the Fed has and can reliably achieve this mandate. “Investors” and “financial firms” do not “have confidence that the Federal Reserve will not let inflation get out of control.” They understand that the Fed has some weapons it can use to fight inflation. They hope the Fed will use those weapons wisely and promptly when needed, but that’s a long way from imaging that the Fed can actually control inflation. As for “households, workers and business”, well, my friends and colleagues don’t sit around saying, “Gosh, I’m sure the Federal Reserve can get the price of gas below $3 by notching overnight interest rates up a bit.”
Inflation got out of control in the late 1960s and 1970s precisely because of a self-reinforcing spiral of wage and price increases. Once the spiral became entrenched, people imagined that it could never be broken and hence inflation expectations became equally entrenched. The spiral was triggered by specific historic conditions. The Vietnam War fostered an extremely low unemployment rate for skilled workers, whose unions were able to push through not only current wage increases but the COLAs that Mr Plosser references. Regularly increasing wages for a significant segment of the workforce both allowed and forced businesses to raise prices. As prices rose, non-union labor also demanded and received higher wages. It was only then, with the year-over-year Consumer Price Index running at 14%, that inflation expectations become “unanchored.”
The Federal Reserve under Paul Volker defeated inflation, but not, as is widely and incorrectly recalled today, by raising interest rates. In October 1979, just three months after his appointment, Volker let it be known that the Fed would no longer target any interest rates. Instead it would focus on the amount of money in circulation, the “money supply,” and leave interest rates entirely up to market forces. Those forces proved vicious, driving overnight rates from 20% to under 10% and back again in less than a year. The turmoil was unsustainable and led to a sharp recession with double-digit unemployment that finally broke the back of inflation. No one at the Fed, and certainly not Volker, could ever admit it, because of the human suffering involved, but this was the outcome they intended and expected. Politically, the Fed could not deliberately create a recession, but it could and did step out of the way and let one happen.
Since then, the Fed has been able to keep inflation under control largely because globalization, productivity and the painful memory of the Great Inflation have made the task so much easier. Some fine tuning, with interest rates always in the low-to-mid single digits, has done the trick. But as Mr Plosser’s speech makes evident, the Fed has taken far too much credit for this long period of relative calm that Ben Bernanke famously labeled the Great Moderation. Even worse, the slippery concept of “inflation expectations” has become central to its thinking.
“Inflation expectations” are measured in consumer confidence surveys, such as those conducted by the Conference Board and the University of Michigan. What the surveys really measure is how worried people are about the cost of living. This distinction may seem nit-picking, but worrying that living costs will rise because global demand has made gasoline more expensive is very different from anticipating a general and sustained rise in prices and wages. In fact, it would be hard to find anybody in the United States today who expects wages to increase much, as evidenced by the very low incidence of strikes.
Instead of causing inflation, higher gas prices have led to marginally lower utilization, resulting in lower oil prices. Once the price of gasoline stabilizes, even if it’s at a historically high level, inflation expectations, as measured by the consumer surveys, will level off too. Other than that, though, nothing much will change. Oh, the Fed’s anti-inflationary rhetoric will cool down a bit, but, rhetoric aside, the Fed would never raise interest rates in the teeth of a recession. Of course, our current economic woes have not yet been officially declared a recession, but that’s a myth for another day.