What caused the Great Inflation?

Prices were already rising fast in the early 1970s, after fixed exchange rates broke down and American money was kept cheap. Oil price shocks in 1973 and 1979 pushed inflation into double figures, and rising pay kept it there until the Federal Reserve raised interest rates sharply from October 1979.

Why prices were rising before the oil shocks

On 15 August 1971 President Nixon stopped exchanging dollars for gold at the price of $35 an ounce, because America's reserves were far smaller than the dollars held overseas. New fixed rates agreed that December soon broke, and by March 1973 the main currencies were floating.

Consumer prices across the OECD rose nearly 6 per cent in 1971. Under Arthur Burns, the Federal Reserve let its key rate fall from 8.98 per cent in February 1970 to 3.30 per cent two years later, while the White House pressed for cheap money. Poor harvests and a simultaneous boom in many economies pushed up food and raw materials; a World Bank grain price index went from about 29 to about 56 between 1972 and 1973.

How the oil shocks fed inflation

After war broke out in October 1973, Arab producers cut output and stopped shipments to the United States. American refiners paid an average of $4.08 a barrel for imported crude in 1973 and $12.52 in 1974, raising the cost of fuel, heating and goods that depend on oil. The Iranian revolution brought a second jump, as Iran's output fell from 5.24 million barrels a day in 1978 to 1.38 million in 1981.

Although oil cost the same in dollars everywhere, the results differed widely. In 1974 consumer prices rose 23.18 per cent in Japan and 6.99 per cent in West Germany. Countries with weakening currencies paid more for oil in their own money. Where workers won big pay rises to keep up, firms passed the cost on, and that loop kept inflation going after oil stopped rising.

Why stagflation confused governments

Governments had expected higher unemployment to bring lower inflation. Instead American unemployment rose from 4.9 per cent in 1973 to 8.5 per cent in 1975 while prices kept climbing, a mix called stagflation. Legal limits on pay and prices in America and Britain slowed inflation only while they lasted.

How the Great Inflation ended

In October 1979 the Federal Reserve under Paul Volcker changed its method and let interest rates rise much further; the federal funds rate averaged 17.61 per cent in April 1980. Two recessions followed, and American unemployment reached 10.8 per cent in December 1982. US inflation fell from 13.58 per cent in 1980 to 3.22 per cent in 1983.

Dear money had a further cost. Banks had lent the oil exporters' earnings on to developing countries, and Mexico's foreign debt grew from $10.67 billion in 1973 to $78.41 billion in 1981. When lending dried up in 1982, Mexico needed rescue loans. Economists still argue over how much of the decade was bad luck with oil and how much bad policy.