The 1970s Stagflation: Causes, Timeline, and Lessons

Under the Bretton Woods system set up in 1944, other major currencies were pegged to the dollar and foreign governments could exchange dollars for US gold at $35 an ounce. That promise limited how far US money growth could outrun the gold stock.

Spending on the Vietnam War and Great Society programs in the late 1960s, combined with an accommodating Fed, pushed inflation from 1.6% in 1965 to 5.5% in 1969. Dollars accumulated abroad, France and other governments converted some into gold, and US gold reserves fell to a fraction of their postwar level. On August 15, 1971, President Nixon closed the gold window. Fixed exchange rates broke down over the next two years, and the dollar became a fiat currency with no external check on monetary policy.

The same August 1971 announcement imposed a 90-day freeze on wages and prices, the first peacetime controls since World War II. Phase II, from November 1971, limited pay increases to 5.5% a year and price increases to an average of 2.5%. Measured inflation slowed to 3.2% in 1972.

The controls produced shortages instead of stable prices. During a second freeze in the summer of 1973, poultry producers drowned chicks rather than raise them at a loss, and beef disappeared from some supermarket shelves as ranchers held back cattle. Controls were phased down through 1973 and expired at the end of April 1974, and prices that had been held down rose in a short burst that added to the 1974 inflation. Monetary growth had continued throughout, so the controls changed when prices rose more than whether they did.

On October 19, 1973, the Organization of Arab Petroleum Exporting Countries embargoed oil shipments to the United States in response to US aid to Israel in the Yom Kippur War, and cut production. The price of oil went from $2.90 a barrel before the embargo to $11.65 in January 1974. Energy is an input to transportation, manufacturing, heating, and food production, so the increase spread through the whole price index.

Inflation, already 6.2% in 1973, reached 11.0% in 1974. Output fell at the same time: the economy was in recession from November 1973 to March 1975, and unemployment peaked at 9.0% in May 1975. Higher oil prices raised costs and cut real incomes at the same time, which is why inflation and unemployment rose together.

Inflation eased to 9.1% in 1975 and 5.8% in 1976. President Ford, in office from August 1974 to January 1977, first promoted the voluntary “Whip Inflation Now” campaign, then signed a tax cut in 1975 as the recession deepened. President Carter, who took office in January 1977, pursued further fiscal stimulus to bring unemployment down from 7.7% in 1976.

The Fed, under Arthur Burns until early 1978 and then G. William Miller, held the federal funds rate below the inflation rate in every year from 1974 through 1977, so real short-term rates were negative. Unemployment fell to 6.1% by 1978, but inflation rose to 6.5% in 1977 and 7.6% in 1978.

The Iranian Revolution cut Iran’s oil output sharply in late 1978 and early 1979, and precautionary buying around the world added to the shortfall. Oil prices more than doubled between April 1979 and April 1980. Inflation rose to 11.3% in 1979 and 13.5% in 1980.

By then people expected high inflation and acted on it. Unions negotiated raises to cover expected price increases, and businesses raised prices in advance of expected cost increases. Those expectations kept inflation high even when the oil shock itself faded, and they had to be broken before inflation could come down.

Paul Volcker became Fed chairman in August 1979. On October 6, 1979, the Fed announced it would target the growth of bank reserves rather than the interest rate, and let rates go where that took them. The effective federal funds rate averaged 18.9% in December 1980 and peaked at a monthly average of 19.1% in June 1981, the highest on record. The average 30-year mortgage rate reached 18.63% in October 1981.

A short recession in the first half of 1980 was followed by a longer one from July 1981 to November 1982. Unemployment reached 10.8% in November and December 1982, the highest in the monthly series that began in 1948, a record that stood until April 2020. Volcker faced heavy political criticism and did not reverse course. Inflation fell from 13.5% in 1980 to 3.2% in 1983 and stayed between 1.9% and 4.3% through 1986.

Central bank independence. Fed officials in the 1970s eased repeatedly when unemployment rose, partly under political pressure. Volcker’s willingness to hold rates high through two recessions made insulation from short-term politics a standard feature of central banks.

Expectations. Once households and businesses expected high inflation, reducing it cost two recessions and unemployment above 10%. Central banks since then have moved earlier against inflation to keep expectations from drifting.

Explicit targets. A public numeric goal gives people something concrete to expect. New Zealand adopted the first formal inflation target in 1990, and the Fed adopted 2% in January 2012.

The Phillips curve. Milton Friedman, in his 1967 presidential address to the American Economic Association, and Edmund Phelps argued that holding unemployment below its natural rate would produce ever-rising inflation rather than a stable trade-off. The 1970s matched that prediction, and the natural-rate idea became part of mainstream macroeconomics.

When inflation reached 8.0% in 2022, comparisons to the 1970s followed. The Fed raised its target range from near zero to 5.25–5.5% by July 2023, about 16 months after it started. Long-run inflation expectations stayed close to their pre-pandemic range this time, and inflation fell to 4.1% in 2023 without a recession, a much cheaper disinflation than 1980 to 1983.