The Unequal Price of Fighting Inflation

What do “ET: The Extra-Terrestrial”, “Dallas”, and “Physical” have in common? They were the top movie, TV show, and song in 1982. (Side note: kids, don’t let your parents tell you that your music lacks taste. The song “Physical” has the line “there’s nothing to talk about unless it’s horizontally. Geez). Anyway, aside from those works of art, something else special happened in 1982. It was the last time inflation was as high as it was in January 2022. That’s right, prices were 7.5 percent higher in January 2022 than in January 2021, a rate of increase last seen those 40 years ago.

So, what happened last time that inflation got this high? Well, as my favorite Professor from College Andy Kozak used to tell it, the Federal Reserve stepped in to stop it. I can still see him standing at the front of the class, saying: “the Fed deliberately, decidedly, and intentionally threw millions of people out of work…and may have saved the economy.” He ended the class that way, making us wonder until the next lecture what he meant. A cliff hanger akin to “who shot J.R.” Dude could teach.

So, what was Professor Kozak talking about exactly? And who exactly were those millions of workers who lost their jobs? Let’s talk about inflation, the Federal Reserve, and the Greatest Recession before the Great Recession.

Inflation and The Fed

The modern Federal Reserve has a two-pronged mandate: 1) keep inflation low; and 2) keep unemployment low. Sounds easy, right? The problem is that those two goals are in tension. When unemployment is low, most people in the economy are making income. This income leads to demand for more goods. But, firms may struggle to meet this demand, since there aren’t a bunch of workers ready to just start working…they already are! The result is that instead of more stuff being made to meet demand, prices increase.

You may say, big deal. Wouldn’t we rather have people working and come what may on prices? Probably not. The issue is that inflation can become a self-fulfilling prophesy. If workers expect prices to rise, then they will demand higher wages. But, this can force firms to raise prices further as labor becomes expensive. The result could be a cycle of rising prices.

So, when inflation is high, the modern Federal Reserve is likely to respond by trying to lower it. To accomplish this lowering, the Fed reduces the amount of money in circulation. Basically, it sells securities to other parties, and takes keeps the money. These sales reduce the amount of money out there in the economy. This reduction means that money becomes “more expensive,” i.e., interest rates increase. And, when interest rates increase, people are able to spend less and jobs are lost. In this way, the modern Fed has been able to maintain fairly stable inflation.

Here’s the thing though…the modern Fed has a dual mandate. The Fed wasn’t always such an inflation fighter…indeed the 1981 recession was its first big bout. Prior to that, it focused much more on employment, and this focus wasn’t always great for prices.

The Great Inflation

The period from 1965 through the early 1980s was known as “The Great Inflation.” Which, sounds a lot more fun than it was (I’m picturing a room full of clowns with helium balloons…which is weird). The figure below shows pre-COVID annual inflation rates, which were perpetually elevated above the modern inflation target of 2 percent.

Figure 1. Annual Inflation versus 2-percent Target, 1960-2020

Source: Federal Reserve Economic Data.

I don’t have the space (nor knowledge!) to hash through all the reasons for this Great Inflation. But, a major contributor was policymakers legitimate fear of another Great Depression. This fear manifested itself in the 1946 Employment Act, which forced the Fed to focus on full employment over inflation. Basically, the Fed tolerated higher inflation to keep unemployment low.

But, as I described above, this didn’t work quite as intended. Employees began to expect higher inflation and ask for higher wages. These higher wages translated to higher prices, and so on. You can see the ratcheting up of inflation in the graph above. This inflationary pressure was exaggerated by internal forces like spending on the Vietnam War and anti-Poverty programs under Lyndon Johnson. And, by external forces like energy crises in 1973 and 1979. These crises forced fuel prices harder, and required workers to ask for even higher wages to afford gas. By the late 1970s, inflation was running over 11 percent. It was clear something had to be done.

A Change of Policy, a New Face, and a Big Recession

Into this environment of rising prices came the change that gave us the modern dual mandate. The Federal Reserve Act of 1977 still tasked the Fed with maintaining maximum employment, but added the words “stable prices.” On top of that change, a new Fed Chairman was in town, Paul Volcker. In his 1979 confirmation hearing, Mr. Volcker made it clear that fighting inflation was his top priority. The stage was set for major change.

And that major change was to rein in the money supply and raise interest rates. For example, from 1979 to 1981 the 30-year Mortgage Rate increased from 11 to 17 percent (not like 11 percent was low). With other interest rates following suit, consumer spending dropped. The result was higher unemployment, which peaked at nearly 11 percent in the Fall of 1981, even higher than the Great Recession.

With the Federal Reserve considering raising interest rates again in the face of more recent inflation, a fair question to ask is who bore the pain of the last Fed-induced recession? Was it spread equally, or concentrated among only part of the economy?

Who Got Hurt?

As the Fed begins taking actions to raise interest rates to fight rising prices, the question of who gets hurt in an inflation fight is important. After all, right now — for the first-time in decades — low- and middle-income workers’ wages are actually growing faster than higher income ones. Will this move towards equality be stomped out as part of an attempt to control today’s inflation?

If the past is any indication, then the answer is probably “yes.” Figure 2 shows the unemployment rate at the peak of the 1981-1982 Recession by Education and Race. Those with a high school degree or less had much higher rates of unemployment than those with some college. Indeed, those with a Bachelor’s or Graduate degree probably hardly noticed the recession. And, Black and Hispanic workers were also hit much harder by unemployment than white workers.

Figure 2. Unemployment Rate in October-December 1981 by Education and Race

Source: Author’s calculation from the CPS IPUMS, University of Minnesota.

Examining the industries that were most affected also reveals a predictable pattern. The construction industry, that relies heavily on borrowing to finance building, was hit the hardest. Unemployment in residential construction peaked in the low 20 percent range. Auto manufacturing, which also relies on consumers having access to low-interest credit was also badly hurt. Unemployment peaked at 24 percent. These jobs were squarely middle class. On the other hand, the finance industry was hardly touched, with unemployment remaining below 4 percent. Thus, middle- and low-income employment seems to have been sacrificed.

What Happens Next?

As our society considers raising interest rates to fight inflation, it seems clear that the effect will fall disproportionately on middle- and lower-income workers. The good news is that it seems unlikely that policy will need to be anywhere near as extreme as it was in the 1980s. Remember, at that time we were coming off decades of high inflation, and policy that treated that inflation as secondary. This pattern created an expectation of high inflation that had been baked into people’s demands for annual income increases. Removing this expectation had a large cost.

Today, we have had four decades of inflation largely hitting a target of 2 percent (just look back at Figure 1). Workers agreements with employers are likely still anchored here…so it seems unlikely to me that inflation is likely to ratchet up to those high numbers in the late-1970s and 1980s (although current events in the Ukraine give me pause). On top of that recent history (or because of it), interest rates entering this bout of inflation were very low, with mortgage rates still around 4 percent. We have a long way to go to get to the damage wrought by 17 percent rates. This time around, the Fed likely has an easier fight.

But, the question still remains — should the Fed pick a fight in the first place? To the extent that inflation is the result of U.S. policy during the pandemic — with three infusions of cash across two administrations — then pulling some money out is likely a good idea. However, if inflation is due to pandemic-related supply issues, then Fed policy is unlikely to help.

I don’t honestly don’t know which of the two is happening, and I suspect that both are. After all, inflation in Europe is also higher than usual, at 5 percent, but not as high as ours. Since they have handed out less cash, this makes some sense — the pandemic raises inflation everywhere, and more in places like the U.S. that made more money available.

In any case, I hope that the Fed comes to the right decision regarding the balances of forces at play. Because the above makes one thing clear — the decision makers with their graduate degrees won’t be the ones to pay if the money supply is targeted too aggressively.

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