Accelerator of inflation

Inflation, war, energy crisis and recession – there are striking parallels between the current global situation and the stagflation of the 1970s. At that time there were geopolitical conflicts such as the attack by Egypt and Syria on Israel in October 1973, followed by the OPEC Arab states’ oil embargo on Israel’s western allies. Today it is Vladimir Putin’s attack on Ukraine, sanctions against Russia and the drastically reduced gas supply from Moscow. At the same time, the OPEC countries are refusing to significantly expand their oil production.
Then as now, war and the energy crisis acted as catalysts for inflation, which of course had set in earlier. In April 1973, a good five months before the Yom Kippur War, inflation in the USA was already 5.3 percent, and in Germany it was even 6.3 percent. In September 2021, a good five months before the Ukraine war, inflation was 5.4 percent in the USA and 4.1 percent in Germany.
During the pandemic, states and central banks have strongly supported aggregate economic demand with transfers, loans, securities purchases and low interest rates, while the production and supply of goods and services have plummeted. Thanks to generous support, household incomes in the USA even rose above pre-corona levels. In Europe, too, governments put together extensive loan and support packages from 2020. The European Central Bank (ECB) accompanied the growing public debt with even larger purchases of government bonds.

Biden has declared war on the price increase

No wonder prices rose as the economy recovered. So the inflation base was already in place, and it rose rapidly in 2021. An end to the war in Ukraine and a fall in energy prices will not be enough to bring the inflation rate down to around two percent. Luckily, inflation is now being taken seriously and no longer trivialized as “temporary”, one might object.

Although US President Joe Biden has declared war on price increases with the “Inflation Reduction Act”, the independent Congressional Budget Office estimates that the law will not reduce inflation, but it will not exacerbate it either. President Richard Nixon, on the other hand, was far less successful in the fight against inflation in the early 1970s – first with unsuitable direct wage and price controls, then he burst the Bretton Woods exchange rate system, which made the inflationary development of the later 1970s possible in the first place .
However, the monetary policy of the US Federal Reserve is currently decisive. Since mid-March it has raised the key interest rate, the Federal Funds Rate, by 2.25 percentage points to the current 2.25 to 2.5 percent. A hike of another 75 basis points should follow in September. Fed Chair Jerome Powell says he is not expecting a recession, but that could change. The US Federal Reserve is obviously now taking the fight against inflation seriously – ultimately, it is likely to accept a mild recession in the process. The Fed reacted very late, but consistently.

The Bundesbank followed Friedman’s recommendations

Powell doesn’t act like Arthur Burns, his predecessor in the 1970s. As early as 1970, Burns was of the opinion that in this “temporary period” of cost-push inflation, restrictive monetary and fiscal policies to combat inflation should be avoided in order not to risk a severe recession. Instead, he recommended direct wage and price controls to Nixon. Burn’s academic opponent Milton Friedman, on the other hand, had correctly argued that inflation could hardly be contained without a temporary slowdown in economic growth and that monetary policy was the right tool to ensure price stability.

Friedman argued that companies could most likely pass on rising costs in the form of higher prices if the central bank supported aggregate demand with cheap liquidity. Interestingly, it was the Deutsche Bundesbank that followed Friedman’s recommendations in the 1970s. It set an inflation target of 2 percent and pursued a pragmatic strategy to limit money supply growth.

In this way, it ensured rapidly rising money market interest rates and also allowed the D-Mark to appreciate significantly. In Germany, three-month interest rates climbed over 14 percent in 1973 and remained in the double-digit range until mid-1974. The inflation rate peaked at just under 8 percent in late 1973 and then declined. It still took almost five years to get a two before the decimal point, but among the G7 countries, Germany was the only one to prevent double-digit inflation rates.

The Fed chair needs staying power

Although Burns allowed the federal funds rate to rise to 12 percent by 1974, he bet on rapid interest rate cuts from the fall of 1974, even though inflation initially remained at 12 percent. According to Burns, since the capacity of the economy is not fully utilized, the price pressure will ease anyway. Although the inflation rate fell briefly to five percent in 1976, it then rose steadily and again clearly exceeded the ten percent mark from 1979.
Powell doesn’t want to make the same mistake as Burns, but he needs staying power to do so. In the euro area, on the other hand, the impression does not arise that the ECB would orientate itself on Friedman and the experience of the Bundesbank. The ECB just raised the deposit rate from minus 0.5 percent to zero percent. There was already an emergency session, but it dealt with interest rate spreads for highly indebted countries and not with inflation. It is true that ECB representatives repeatedly state that price stability has priority. But words have not been followed by enough action. One is tempted to warn the ECB not to give the burns of our time, please.

Tank discounts are not a suitable means

And what should governments do? Fuel rebates and other interventions to cushion rising energy costs can bring inflation down somewhat in the short term. But by supporting household demand, these measures will soon fuel inflation again. It would be better if the high energy prices were allowed to take effect, thereby making maximum use of potential savings – and thus becoming independent of the Russian warmonger Putin as quickly as possible.
After the oil embargo in 1973, the USA expanded its own oil and gas production, in particular using fracking methods. They have thus become a net gas exporter. Today, Germany hopes to get through the winter not least with American and Canadian liquid gas. There are natural gas deposits in northern Germany that are eligible for subsidies, which account for a multiple of Russian imports.
However: Exploration and promotion of deposits would first have to be approved. If Germany feels too bad about that, we shouldn’t be surprised if our allies’ declarations of solidarity with gas are rather muted.

The author: Volker Wieland is Managing Director of the Institute for Monetary and Financial Stability at the Goethe University in Frankfurt.

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