The Great Inflation

The Great Inflation was a seventeen-year episode of rising prices in the United States, beginning around 1965 and not decisively broken until the early 1980s. It started modestly—a few percentage points annually—but accelerated into double digits by the mid-1970s, producing the stagflationary nightmare of simultaneously high unemployment and high inflation. The episode forced a wholesale rethinking of how central banks manage monetary policy and cost the US economy trillions in lost output and real wages.

The Origins: Spending Without Discipline

The Great Inflation did not arrive suddenly. It accumulated gradually, the result of conscious policy choices layered on top of structural changes in the economy. By the mid-1960s, the US was at full employment and robust growth. President Lyndon Johnson, flush with political victory, pursued an ambitious agenda: the Great Society domestic programs, coupled with massive military spending for the Vietnam War.

The arithmetic was straightforward and reckless. The federal government was spending far more than it was collecting in taxes. To finance this gap, the Treasury was borrowing, which required the Federal Reserve to provide accommodative monetary policy—that is, to keep interest rates low and money supply growing rapidly. Without this monetary accommodation, government borrowing would have driven up interest rates, crowding out private investment. The Fed, under chairman William McChesney Martin, was reluctant to constrict the economy and raise unemployment during a war. It kept the monetary pedal pressed.

This created the first stage of inflation: too much spending chasing too few goods. Prices began creeping up in 1965–1966. The Keynesian orthodoxy of the time held that this was manageable—a trade-off between inflation and unemployment, with policymakers free to choose a point on the Phillips Curve. If a bit of inflation was the price of low unemployment, it seemed a reasonable bargain.

The Shock: Oil, Expectations, and Wage-Price Spirals

The Great Inflation accelerated catastrophically in the early 1970s, driven by two structural shocks. First, the breakdown of the Bretton Woods system of fixed exchange rates in 1971–1972 allowed the US dollar to depreciate, making imports more expensive. Second, and more dramatically, the Arab-Israeli war of 1973 led to an oil embargo and a tripling of crude oil prices within months.

Oil-price shocks should be temporary: a one-time rise in the price level, not a permanent acceleration of inflation. But by the mid-1970s, the inflation had become entrenched in expectations. Workers, burned by years of rising prices eroding their real wages, demanded larger wage increases. Employers, expecting continued inflation, were willing to grant them. This created a wage-price spiral: wages rose to catch up with inflation, which pushed up prices, which prompted demands for even higher wages.

The problem was that once inflation became embedded in expectations, the real economy faced a genuine dilemma. To break the spiral required reducing the growth of money supply and aggregate demand. But contracting demand meant unemployment would rise. There was no free lunch: the implicit Phillips Curve trade-off became real and painful.

Stagflation: The Impossible Combination

By 1974–1975, the US economy exhibited a combination of conditions that the dominant economic models of the time said should not coexist: high inflation and high unemployment, simultaneously. This condition—called stagflation—seemed to refute the Keynesian orthodoxy that had dominated American economics since the 1950s.

Unemployment reached 9 percent in 1975 while inflation was in double digits. Real wages—the purchasing power of workers’ earnings—were falling. Real interest rates—the return on saving adjusted for inflation—turned negative, meaning savers were losing money in real terms by holding bonds or bank deposits. Asset prices fell in real terms. The stock market crashed. Those who had believed that inflation and unemployment could not both be high at once faced a bewildering new reality.

The cause, in retrospect, is clear: the Fed had allowed inflation to become embedded in wage and price expectations, and neither wages nor prices were flexible downward. Once expectations shifted, there was no policy lever that could deliver low unemployment and low inflation simultaneously. The economy had to be cooled to break the inflation—which meant a period of elevated unemployment and real hardship. The only question was how severe and how long.

The Volcker Shock: Breaking the Chain

Paul Volcker became Federal Reserve chairman in August 1979, just as inflation was accelerating toward 15 percent annually. He concluded, correctly, that the only way to restore price stability was to accept a severe contraction. The Fed would raise interest rates dramatically, constrict money growth, and maintain that discipline until inflation expectations collapsed.

The policy worked, but the cost was brutal. The US economy fell into deep recession in 1981–1982. Unemployment reached 10.8 percent, the highest since the Great Depression. Manufacturing employment collapsed. Car plants and steel mills shut down or ran at a fraction of capacity. Small businesses failed. Real estate values plummeted. For those in affected industries, it felt apocalyptic.

But by 1982–1983, inflation was breaking. Wage growth slowed as workers accepted that the inflation would not return. Pricing power eroded. By 1983, inflation had fallen to 3 percent and was heading lower. Real interest rates turned positive. Real wages, after a decade of decline, stabilized. The S&P 500 began its thirty-year bull market.

Volcker’s victory came at a price, but it was finite: a severe but temporary contraction, rather than a decade of stagnation. This convinced economists and policymakers that inflation expectations could be broken if a central bank had the credibility and will to endure short-term pain for long-term gain. The lesson would reshape monetary policy doctrine globally.

Intellectual Reckoning: Friedman and the Expectations Revolution

The Great Inflation discredited Keynesian orthodoxy and vindicated critiques that had been brewing for years. Milton Friedman and other economists associated with the “monetarist” school had argued throughout the 1960s that inflation was fundamentally a monetary phenomenon—that the Federal Reserve could print money endlessly, pushing prices up, but could not sustain high employment in the long run. “In the long run,” Friedman wrote, “there is no trade-off between inflation and unemployment.”

The Phillips Curve—the idea that there was a stable, exploitable trade-off—was overthrown. Economists like Robert Lucas and Thomas Sargent developed theories of “rational expectations,” arguing that individuals would rationally anticipate the consequences of policy. If the Fed announced it would increase money supply, people would expect inflation and adjust wages and prices upward immediately, without any benefit to employment.

These ideas, once heretical in mainstream economics, became orthodoxy by the late 1980s. They implied that the Fed should focus on controlling inflation, not on trying to fine-tune employment. Central banks around the world adopted this framework, establishing explicit inflation targets and independence from political pressure to boost employment or growth.

Legacy: The Taming of Inflation

The Great Inflation left deep scars. It destroyed the savings of anyone who had lent money at fixed interest rates before the crisis. It fractured social trust—workers felt robbed of real income, savers felt punished, and unemployed workers bore the cost of the remedy. It accelerated the deindustrialisation of America’s rustbelt as manufacturers, facing stagflation and then brutal Volcker-era interest rates, moved production overseas or automated ruthlessly.

But it also established a powerful anchor for inflation expectations that would persist for decades. Central banks, once seen as tools of political expediency, were granted technical credibility. The Federal Reserve’s willingness to engineer a severe recession to break inflation expectations demonstrated that it would not allow inflation to spiral out of control again. This expectation became self-fulfilling: businesses and workers moderated their wage and price demands, making it easier for the Fed to maintain price stability without such brutal contractions.

For roughly thirty-five years—from the early 1980s until 2021—inflation remained tame in the developed world, usually between 1 and 3 percent. The Great Inflation seemed a historical curiosity, a lesson learned and never to be repeated. The cost of that learning—the trillions of lost output, the ruined careers, the real hardship of the Volcker recession—faded from public memory.

Until, of course, inflation returned.

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