The Return of Inflation?

Forget the housing collapse, the "credit crunch" and—in isolation—higher oil prices. The real economic menace may be resurgent inflation, which is the broad rise of most prices. To understand why, some history helps. The government's worst domestic blunder since World War II was the unleashing of high inflation: In 1960, annual inflation was 1.4 percent; by 1979, it was 13.3 percent. This terrified Americans, who feared falling living standards. It also destabilized the economy, causing harsher recessions that culminated in 10.8 percent unemployment in 1982.

We don't want to go there again, and Federal Reserve Chairman Ben Bernanke has been insisting that we won't. In a recent speech, he argued that the economy today is much different from what it was in the mid-1970s. He's right. In 1974, inflation (as measured by the consumer price index) was 12 percent. Unemployment in the parallel recession peaked at 9 percent in early 1975. We're not close to that havoc. Unfortunately, Bernanke's comforting analogy is misleading. The question is not whether it's 1975; it's whether it's 1966.

It was then that the inflationary psychology, which later led to so much grief, took hold. Vietnam War spending and the Fed's easy-money policies created an economic hothouse. Government officials and most academic economists underestimated the danger. Inflation crept from negligible levels to 3.5 percent in 1966 and 6.2 percent in 1969. There are eerie parallels now. From 1997 to 2003, inflation averaged slightly more than 2 percent. Now it's 4 percent, and some economists soon expect 5 percent. Hmm.

To be sure, differences abound. Then, we had a classic wage-price spiral. Strong consumer demand allowed businesses to raise prices, which spurred demands for higher wages that companies paid because they needed the workers and could recover the costs through higher prices. In 1959, labor costs rose 4 percent; firms could offset most of that through efficiencies (aka "productivity"). By 1968, labor costs were up a less-forgiving 8 percent.

By contrast, today there's not yet a wage-price spiral. Inflationary pressures seem to originate mostly in rising raw materials prices. In 2002, oil was $25 a barrel; now it's $135. Corn was $2.30 a bushel; now it exceeds $7. Copper was 70 cents a pound; now it's $3.80. Meanwhile, a powerful anti-inflationary force—cheaper manufactured imports—is waning. The weaker dollar and higher transportation costs have raised import prices. In the past year, prices for imported consumer goods (excluding autos) are up 3.6 percent.

We seem to be hostage to global forces. Economists Richard Berner and Joachim Fels of Morgan Stanley call this the "new inflation," because it's not easily squelched by domestic policies. Up to a point, that's true. Although the Fed influences interest rates, it doesn't own oil rigs or cornfields. Long-term price relief for oil involves switching to more-fuel-efficient vehicles and increasing worldwide, including American, oil production. Removing subsidies for corn-based ethanol would reduce food price pressures.