Stagflation in the 1970s

Until the 1970s, many economists assumed a stable inverse relationship between inflation and unemployment. Prior data had supported the idea that unemployment fell as inflation rose, and that unemployment rose as inflation fell.

Stagflation in the 1970s presented a unique economic challenge: a combination of slow economic growth alongside rapidly rising prices, challenging prior assumptions and leading economists to examine the causes and policies that would end the stagnant period.

The 1970s 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.

Meanwhile, unemployment had exceeded standards set in two prior decades, and growth was uneven. The economy was in a recession from December 1969 to November 1970 and again from November 1973 to March 1975. When not in a recession, the economy saw real gross domestic product (GDP) grow at a rate of above 5% between 1972 and 1973 and mostly above 5% between 1976 and 1978. This set the stage ahead of oil price shocks that would curb growth while fueling inflation.

As a result of the Arab oil embargo, crude oil prices spiked in 1973. This was followed by another price jump at the decade's end, as the U.S. embargoed oil from Iran. In late 1979, the price of West Texas Intermediate crude oil skyrocketed, peaking in the spring of 1980 at nearly $150 per barrel in 2024 dollars.

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.

High inflation and uneven economic performance soured the national mood. In November 1979, only 19% of Americans were satisfied in the U.S. (In comparison, 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 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.

The Bottom Line

Until the 1970s, economists assumed an inverse relationship between inflation and unemployment.

Typically, during periods of economic expansion, demand is expected to drive up prices, encouraging businesses to grow and hire additional employees. Conversely, during a recession, lower demand traditionally leads to unemployment, cap price increases, and lower inflation.

Stagflation in the 1970s was a period that saw both slow economic growth and high inflation, challenging long-held assumptions.