Until the 1970s, many economists relied on a stable inverse relationship between inflation and unemployment. Data collected since the 1860s suggested unemployment fell as inflation rose and rose when inflation fell.
During economic expansion, demand was expected to drive up prices, encouraging businesses to grow and hire additional employees. During a recession, lower demand would lead to unemployment, cap price increases, and lower inflation.
The stagflation of the 1970s, a combination of slow growth and rapidly rising prices, challenged prior assumptions, leading economists to examine the causes and policies that would end the stagnant period.
- Stagflation in the 1970s combined high inflation with uneven economic growth.
- High budget deficits, lower interest rates, the oil embargo, and the collapse of managed currency rates contributed to stagflation.
- Under Federal Reserve Board Chair, Paul Volcker, the prime lending rate was above 21% to reduce inflation.
- Inflationary pressures eased as oil prices and union employment fell, limiting the growth of costs and wages.
That '70s Economy
The 1970s saw growing federal budget deficits boosted by military spending during the Vietnam War, Great Society social spending programs aimed at fighting poverty, and the collapse of the Bretton Woods agreement.
These issues were compounded by a tripling in crude oil prices as a result of the Arab oil embargo, followed by a near-tripling at the decade's end as the U.S. embargoed oil from Iran. In November 1979, the price of West Texas Intermediate crude oil surpassed $100 per barrel in 2019 dollars, peaking at $125 the following April. That price level would not be exceeded for 28 years.
Soaring energy prices fueled a wage-cost price spiral and widespread price hikes across the full spectrum of economic activity. Frequent recessions raised unemployment without cooling inflation. The Federal Reserve focused on propping up growth and was powerless to tame soaring prices. Faced with external economic shocks, policymakers allowed inflation expectations to settle in, discouraging investment.
Unemployment exceeded standards set in two prior decades, and growth was uneven. The economy was in recession from December 1969 to November 1970 and again from November 1973 to March 1975. When not in a recession, the economy often grew with real Gross Domestic Product (GDP) growth above 5% in 1972-73 and mostly above 5% in 1976-78, ahead of oil price shocks that would curb growth while fueling inflation.
High inflation and uneven economic performance soured the national mood. In November 1979, only 19% of Americans were satisfied in the U.S., compared with 22% in April 2022, according to a Gallup survey. Americans' satisfaction with the national trend in this poll peaked at 71% in 1999. In the 1970s, lower living standards and declining confidence in economic policy were commonplace.
The Policy Response
U.S. monetary policy during the 1970s was guided by the Keynesian school of economic thought, named for 20th-century British economist John Maynard Keynes. Keynesian theory informed the government and central bank's response to the Great Depression.
The Keynesians of the 1970s hoped that increased government spending and lower interest rates would counter downturns in aggregate demand and relied on the Phillips Curve, which describes the typically inverse relationship between inflation and unemployment.
Critics of Federal Reserve policies during the 1970s note that the Fed, in accepting higher inflation as its preferred alternative to a rise in unemployment, fostered damagingly high inflation expectations.
"The Fed's credibility as an inflation fighter was lost," then-Fed governor Ben Bernanke said in a 2003 speech. "The unmooring of inflation expectations greatly complicated the process of making monetary policy; in particular, the Fed's loss of credibility significantly increased the cost of achieving disinflation."
The resulting inflation was so high it required two recessions to reduce. Under Fed Chairman Paul Volcker, the prime lending rate exceeded 21% to help curb growth. Inflation and inflation expectations remained high when Volcker's tightening began. Rising interest rates lowered output and employment rather than capping prices, which continued to increase.
The Rise and Fall of Monetarists
Arthur Burns led the Federal Reserve from 1970-1978 and was influenced by Keynes. The monetary tightening by the Volcker Fed followed more closely with the philosophy of Milton Friedman, an American economist and leading proponent of Monetarist theories, who argued money supply was the primary determinant and cause of inflation.
By limiting the money supply by increasing interest rates, the Volcker Fed brought inflation under control. However, the growth of the financial industry and the advent of new investment and credit vehicles led money supply measures to increase much more rapidly than inflation.
The reduced bargaining power of workers following the decline in union employment after the recession of the early 1980s, the economy's reduced oil consumption, and a slump in energy prices also relieved inflationary pressure.
Deflation vs. Disinflation
Disinflation is a slowdown in the inflation rate, while deflation is the opposite of inflation and represents a broad price decline.
How Does the Current U.S. Economic Climate Compare to the Stagflation of the 1970s?
In 2022, weak growth and elevated inflation mimicked the economic stagflation of the 1970s.
As in the 1970s, an era that ended with a global recession and a series of financial crises, the economists and policymakers of 2022 battled with the consequences of rapidly tightening financing. During the 2020 global recession, global growth collapsed but rebounded to 5.7 percent in 2021 due to fiscal and monetary policy accommodation. However, growth is expected to slow through 2024 because of the war in Ukraine, the easing of demand, and the withdrawal of policy support amid high inflation.
What Steps Did Fed Chair Paul Volcker Take to Curb Inflation?
Volcker switched the Fed policy from targeting interest rates to targeting the money supply. Easy credit was replaced with very expensive credit, reversing the policies of former chairs. Volcker's policies enabled the long economic expansions of the 1980s and 1990s and the Fed grew more confident in the markets.
Where Should You Invest During Stagflation?
Real estate investments tend to have a low correlation to stocks, and housing is still needed during a slowdown. Rental prices usually keep pace with inflation, even with a depreciating dollar.
The Bottom Line
A country's central bank and its policies often struggle to keep up with a changing economy. Former Fed chair Ben Bernanke argued in a 2003 speech for "constrained discretion," giving Fed officials broad discretion with clearly defined policy objectives. The 1970s stagflation required the Fed to maintain its credibility by acting promptly to limit long-term deviations from a targeted inflation rate, a plan to pursue stable prices by aiming for a rate averaging 2% over the long run.