As I showed over the weekend, the jumps in inflation during the 1970’s were due to real GDP reaching the Long-run aggregate supply curve (LRAS). But underlying the inflation of the 1970’s were dynamics of growth, optimism, speculation, small business development, union bargaining power and a surging labor force from desirous baby-boomers coming of age as pointed out by Steve Randy Waldman. (Desirous is my painting stroke.)
So when real GDP hit the LRAS zones in the 1970’s, inflation resulted. Inflation rose to over 11% in both recessions. The LRAS zone is marked by the paths of real GDP and effective demand. Where the paths cross (see dashed black lines), the LRAS zone begins. Here are the graphs that I made for the 1970’s… (2009 dollars)
So it is more than obvious that the inflation jumps were created in the LRAS zones as the economy went into recession during the 1970’s. But there were forces to produce inflation. Even though the Fed rate was balanced to bring inflation down to 3% during the 1970’s, inflation moved from 3% before the 1973 recession, rose to 11% during that recession, fell to 6% after that recession and then rose again to 13% during the 1980 recession.
In spite of correct Federal Reserve policy, the financial sector kept feeding the economy and creating money even at higher interest rates. The mood of growth and optimism emanating from the baby-boomers kept the money supply growing in spite of higher interest rates. A higher Fed rate did not matter so much in that atmosphere of growth and decadence in the 1970’s. In essence, society did not respect the intent of the Fed rate to control the economy. They borrowed and the banks lent money. Money was created in spite of a higher Fed rate.
What happened during the 2008 crisis? (This graph puts real GDP in 2005 dollars)
We saw no inflation result as real GDP reached the effective demand limit. The factors underlying a strong inflation were not there as they were in the 1970’s. There is more debt overhang now. Net worth took a hit as the bubble popped. The baby-boomers are leaving the labor force to some extent, or are keeping jobs that could make room for younger workers. Also, there isn’t the mood for growth in spite of interest rates.
What about the next recession? (2009 dollars)
We see the same typical pattern before a recession. Real GDP is trending horizontal at a low inflation rate, while effective demand trends toward the meeting place with real GDP. Where they will meet establishes the LRAS zone. What will inflation do as real GDP enters the LRAS zone? Are there dynamics to support a big rise in inflation? I do not see those dynamics. More baby-boomers will leave the labor force. There may even be a bubble popped to bring down net worth. Debt overhang will still be there. Labor has no power to ask for higher wages.
Will we have deflation? Most likely we will see an effort by inflation to rise, but if there is a bubble popping sound, inflation will back off. Pretty much as we saw in 2008. Deflation may be stronger in the next recession.
Will the next recession be dramatic? Oh yes… there will be labor issues, student default issues, government debt issues, deflation issues, derivatives issues, emerging market issues, on-going QE issues and more.