Samuelson: 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.

Still, all large inflations involve "too much money chasing too few goods," as economist Milton Friedman often noted, and this episode is no exception. The Fed's easy-money policies have global effects. Many countries peg their currencies to the dollar—formally or informally—and shadow Fed policies. Meanwhile, oil producers and other commodity exporters have been flooded with dollars; in practice, the extra cash allows them to run easy-money policies. The result is that despite the U.S. slowdown, much of the world is booming. Developing countries, now about half the global economy, have been growing at about 7 percent since 2002. Higher inflation is a worldwide phenomenon. In China and India, it's about 8 percent. In Russia, it's 15 percent.

One antidote to rising raw materials prices is for the Fed to reverse its easy-money policies. Combating inflation is rarely popular or easy, because it involves slowing the economy, even inducing a recession, to relieve pressures on prices and wages. Unemployment rises. There are usually plausible reasons for waiting. Surely there are now. Housing remains in disarray. More loan defaults could increase bank losses. No matter what the Fed does, there are dangers. Perhaps inflation will spontaneously subside (as some Fed officials hope) because the economy is already weak.

But similar arguments for delay were made in the 1960s, with disastrous results. The resulting inflationary psychology made inflation harder to extinguish. The initial unwillingness to take a modest slowdown or recession led to deeper subsequent recessions. There are now signs that we are at a similar juncture. Surveys show that people's "inflationary expectations," after years of stability, are rising. The Fed is holding its key interest rate at 2 percent, well below prevailing inflation. In the 1970s, this condition stoked inflation. An indecisive Fed risks repeating its previous blunder.