1970s Inflation Explained

A decade of oil shocks, loose monetary policy, and unanchored expectations produced stagflation — high inflation and weak growth at the same time — and set the stage for the Volcker era.

The end of a stable era

The decades after World War II had been marked by relatively stable prices, but that began to break down as the 1960s turned into the 1970s. Heavy government spending on the Vietnam War and Great Society programs pushed up demand without a matching increase in taxes, and in August 1971 President Nixon ended the dollar's convertibility into gold, effectively closing the Bretton Woods system of fixed exchange rates. That gave U.S. monetary policy more freedom, and, in practice, more room to run loose.

Two oil shocks

In October 1973, OPEC imposed an oil embargo in response to the Yom Kippur War, and oil prices roughly quadrupled within months. Higher energy costs rippled through the entire economy, pushing up the price of nearly everything that depended on transportation and manufacturing. Just as the economy was adjusting, the 1979 Iranian Revolution disrupted oil supply again, triggering a second oil shock and a fresh surge in prices.

Policy mistakes that let inflation take root

The oil shocks were the trigger, but policy choices let inflation become entrenched. The Federal Reserve under Arthur Burns kept monetary policy too accommodative for too long, often under political pressure to avoid triggering a recession. Nixon's wage and price controls, imposed in 1971 to suppress inflation directly, briefly held prices down before unleashing a rebound once they were lifted. Each time the Fed eased up to support growth, inflation expectations ratcheted higher, and by the late 1970s the U.S. consumer price index was rising at a double-digit annual pace.

Stagflation: the worst of both worlds

What made the 1970s distinct was the combination of high inflation with weak growth and high unemployment at the same time — a pairing that conventional economic theory of the era, built around a tradeoff between inflation and unemployment, said shouldn't happen together. The term "stagflation" was coined to describe it. Wages struggled to keep pace with prices, real incomes stagnated, and confidence in the Fed's ability to control inflation eroded along with it.

For financial markets, stagflation was punishing in a way ordinary recessions aren't. Bonds lost value as inflation eroded their fixed payments, stocks struggled as higher costs squeezed corporate margins and higher rates pressured valuations, and there was no obvious asset class offering shelter — a combination that made the decade one of the worst stretches on record for a traditional stock-and-bond portfolio.

Setting the stage for Volcker

By the end of the decade, inflation expectations were thoroughly unanchored: businesses and workers assumed prices would keep rising and set wages and contracts accordingly, which became a self-fulfilling force in itself. Breaking that cycle would require a policy response far more aggressive than anything tried earlier in the decade — which is exactly what arrived when Paul Volcker took over the Federal Reserve in 1979.