October 26, 2005
Inflation Breakout: Not This Time
By Robert Samuelson

WASHINGTON -- We have all the telltale signs of an inflation breakout: a big jump in oil and energy prices; an increase in the price of gold, often an inflation hedge; a low unemployment rate (5.1 percent in September, despite Katrina) that could push up wages. To anyone old enough to remember, the situation seems eerily reminiscent of the 1970s, when oil prices soared and inflation reached peaks of 12.3 percent in 1974 and 13.3 percent in 1979. Well, folks, it ain't gonna happen this time.

Here are three reasons: (1) The Federal Reserve won't let it happen -- and the nomination of Ben Bernanke to succeed Alan Greenspan as Fed chairman won't change that. The Fed would tolerate a recession before again permitting inflation to go bonkers. (2) The economy has become vastly more competitive since the 1970s. It's harder for companies to raise prices, because they face imports or low-cost domestic rivals. (3) Productivity has also improved since the 1970s, helping companies absorb some cost increases without raising their prices (``productivity'' means ``efficiency'' and is measured by output per hour worked).

It's true that the first challenge of a Bernanke Fed will be to deal with the recent inflation news, which has been abysmal. September, the Consumer Price Index (CPI) was up 4.7 percent from a year earlier, the largest 12-month gain since June 1991. But the overwhelming cause was the explosion of energy prices, not a general rise of most prices. Economist James Hamilton of the University of California at San Diego cites this revealing fact: even if no prices outside energy had increased, the CPI would still have risen 2.7 percent. In the past year, energy prices (mostly gasoline, heating oil and natural gas) are up 34.8 percent. Gulp.

Because we think that higher oil prices caused double-digit inflation in the 1970s, we fear it could happen again. The trouble with this logic is that the underlying facts are wrong. High oil prices didn't cause the 1970s' double-digit inflation; they simply made it slightly worse. Look again at those peak CPI numbers: 12.3 percent for 1974 and 13.3 percent for 1979. Now, look at the figures without the effect of energy prices: 11.7 percent (1974) and 11.1 percent (1979). Or consider this: in the 1960s, well before any oil ``shock,'' inflation went from 1 percent to 6 percent.

``People make a mistake when they attribute inflation (mainly) to oil prices,'' says Hamilton. ``It was what the Federal Reserve was doing before the oil shocks that made for inflation.'' What the Fed was doing was following easy money and credit policies. The economy repeatedly ``overheated,'' creating a stubborn wage-price spiral and pervasive inflationary psychology. Countless economists, left and right, have concluded that oil prices were not the principal inflation culprit.

The great continuity between Greenspan and Bernanke is that both accept this basic analysis. They believe that the Fed's lax policies fostered high inflation which in turn destabilized the economy. It led to more frequent recessions, higher average unemployment and lower average gains in incomes and living standards. The Fed's first job, then, is to restrain inflation, because almost everything else depends on it.

Probably most economists now believe this, but much of the public still clings to the myth that high oil prices caused high inflation. It's apparently indestructible. Why is this? One reason is that it's a simple story; it's easy to understand and remember. Better yet, it puts most blame on foreigners -- those ``greedy'' oil exporters. It plays to our victimhood. Inflation wasn't our fault; it was what others did to us.

The truth is that the high inflation of the 1970s was mostly self-inflicted. It was the consequence of bad economic ideas. What prompted the Fed to follow easy-money policies was the belief -- then dominant among mainstream economists -- that there is a stable ``trade off'' between inflation and unemployment. In effect, you could juice the economy, and you'd get a big drop in unemployment and a slight rise in inflation. It seemed like a good deal.

Unfortunately, the theoretical bargain didn't work in practice. The Fed unwittingly promoted both higher inflation and higher unemployment. By 1980, wages and fringe benefits were rising at nearly 11 percent annually. Only the brutal 1981-82 recession, with peak unemployment near 11 percent, reversed the policy and the inflationary psychology.

In coming months, higher energy prices may recede -- or they may filter into other prices, from plastics to pizza deliveries. Inflation may temporarily worsen, but it will move permanently higher -- say, from 2 percent to 5 percent -- only if the Fed under Greenspan and Bernanke permits it to move higher. That is, if the Fed pushes out so much money that it creates enough artificial demand to trigger a new wage-price spiral. Under Greenspan, the Fed buttressed its credibility by raising interest rates when necessary to suppress inflation, even at the risk of a short-term recession. The last thing Bernanke wants is to squander this hard-won reputation.

© 2005, Washington Post Writers Group

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