Inflation has dominated the business news of late, for the first time in three decades. 

In fact, the last time we discussed the rate of change of prices, it was for fear not of inflation, but of deflation in the wake of the Global Financial Meltdown more than a decade ago.

It turns out that an understanding of deflation is actually important in dealing with inflation at times as well, so let’s have a primer. 

The Federal Reserve monitors inflation carefully as the rate of change of prices in the economy affects business behavior. In fact, it monitors the rising (and occasional falling) of energy prices, wholesale prices, and the retail prices that most affect consumers. 

Five decades ago, the Federal Reserve tended to focus much more on the money supply and interest rates. Then the Great Stagflation of the late 1970s occurred, spurred on by OPEC’s response to U.S. support of the Isreali invasions of the 1960s and U.S. actions against some Arab nations. OPEC responded by blocking oil exports to the United States. Many of you may recall the resulting oil shortages, long gasoline lines, and a knee-jerk nationalistic response against higher fuel efficiency foreign automobiles that threatened a U.S. automobile industry that held far more influence than it does today. 

The oil shortages, boycotts, and Buy-American movement all created problems in the supply chain well before supply chain management was a well-bandied term. 

The resulting energy and goods shortages resulted in a large increase in energy costs, which trickled down to all sorts of wholesale and retail goods that necessarily also depended on energy for their production and transportation. 

Like a rat moving through a snake, that inflationary bulge could have run its course, with some minor but controllable symptoms. Prices inevitably rise, and this results in some panic stockpiling that even further imbalanced demand and supply and amplified inflation, if not well managed. 

On the tail end of that amplified mini economic crisis is sometimes a deflation as prices fall back to normal once the supply chain resumes its usual efficiency. That deflation can be problematic too because, just as people accelerate buying when they fear prices will rise, they delay buying when they believe prices may fall. Either disruption is unwelcome, but both, in moderation, are acceptable. 

A laser focus on inflation was not such a central purview of the Federal Reserve then, but would become so soon thereafter. You see, we as an economy did not handle these disruptions well. 

As you can see, the initial inflation was supply-side, and related to either a temporary or semi permanent increase in energy prices, depending on how the OPEC crisis was handled. What happened next was a blunder that caused the Federal Reserve to forever change its priorities, but not until heads flew, in this case the head of the Fed. 

In the wake of that lesson, and a decade after the 1979-81 stagflation that followed, central banks, led by the Bank of Canada, began to consider inflation as the key economic variable to target and keep in line. But, before that policy change, the Federal Reserve was confronted with deficient demand and a recession that ended Carter’s presidency and elected President Reagan. 

The textbook response to a stagnating economy is stimulation, then often by increasing the amount of available money. But money, like all commodities, becomes less valuable, and you then need to absorb more of it, when its supply increases. 

At the same time, the organized labor movement was about three times the size and clout of today. Renewed contracts invariably contained a new Cost of Living Allowance (COLA) clause that resulted in an automatic increase in wages when prices increase. Producers passed those higher costs on in the form of higher product prices. 

In doing so, the supply-push inflation became institutionalized. Everybody expected higher prices and consequently demanded higher wages, which pushed inflation up into double digit levels. 

Of course, people will not lend if they don’t receive an interest rate that at least covers the decreased value of the payments they earn in return, so interest rates rose to double digit levels as well. 

The combination of increased interest rates and institutionalized inflation combined for a stagnating economy and inflation - hence stagflation. Businesses that had borrowed at the high interest rates went bankrupt. Housing construction plummeted under the pressure of high mortgage rates, and poor Paul Volcker made the painful but correct decision as the chair of the Federal Reserve to depress demand to rid our economy of an expectation that inflation will continue to accelerate into hyperinflation territory. While he absolutely did the right thing, he lost his job nonetheless under a new administration that had run against the perceived economic follies and economic centralization of the Carter Administration. 

Ever since that troubling period was digested by central banks everywhere, the primary goal of monetary policy is to use the tools at its disposal to keep the inflation rate around 2% and ensure greater economic predictability. 

You may ask, why 2%? Wouldn’t no inflation be even better? Yes, in a perfect world, it would be, but economies have their fickle side. By creating a 2% bias, central bankers hoped that any errors or shocks would not drift our economy into deflation. They all saw how the delayed purchasing by Japanese consumers dealing with their decades-long deflationary economy is much more difficult to reverse than a slightly too high inflation. 

The western world became so confident of our central bank superpowers that we never really thought much of inflation or deflation until the financial meltdown of 2008. Once again, the Fed found itself between the rock of rapidly rising housing and energy prices and the hard place of a looming financial meltdown. On the one hand, they should slow the economy down to reduce inflation, but, on the other hand, they realized a financial meltdown begs for economic stimulation. So, for too long they did nothing, as chronicled in my book “Global Financial Meltdown” that came out just as everything hit the fan. 

Just as in the Great Stagflation, the Great Recession induced policy paralysis that prolonged pain. The Feds are very concerned this may happen again. 

We’ve documented the supply chain problems that are increasingly recognized in the popular press. Labor shortages and strikes are also resulting in increased wage concessions and this is again beginning to institutionalize inflation just as we saw in the 1970s. 

The issue is then whether to “wait and see” with a go-slow approach to pull back inflationary pressures, as recommended by Federal Reserve President Jerome Powell, or to accelerate the taper, a Fed-speak term referring to a more rapid normalization in interest rates from historically low levels, and a discontinuation of quantitative easing, the Fed’s decade-long purchase of securities to force up their price, and hence reduce their yields. Such a taper is advocated by Lael Brainard, a brilliant female economist who many hope will secure the upcoming Federal Reserve Chairman appointment. Current Federal Reserve Chairman Powell, a political scientist, lawyer, and investment banker, has conducted a far more gradual and politically appeasing monetary that has kept interest rates at historically low levels for more than a decade, a policy which tends to amplify rather than moderate inflation.

You probably know by now that I am one willing to take medicine that induces pain in the short term if the long term benefits are worth it. Economists are typically of that ilk, which is why you very rarely see economists in politics. In keeping their interest rate so low for so long, the current Fed has forfeited its most potent tool to cool down inflationary expectations. To not raise interest rates to refill the arrows in their quill is to gamble with the economy. 

We know this. Inflation is high, and all indications are that it may go higher for some time before the economy is back in whack. Bold action, well beyond an order for a couple of ports to put on an extra shift, will be needed to keep our economy on the rails and expectations-augmented inflation at bay. Commentators who argue that the new physical and social infrastructure bills will increase efficiencies and help repair the supply chain are probably a little bit correct, but that will be far too little and far too late. 

As Keynes said, in the long run we are all dead. What we need now is a stronger hand at the till, a more cohesive and less coddling economic policy, and a movement consistently in the right direction. To complicate matters is the existential need to transition much more quickly to a net-zero carbon economy, and start reaping those benefits as a world energy efficiency technology leader before anyone else. Instead, we are talking about flooding the market with cheap gasoline from the Strategic Petroleum Reserve and continuing to offer subsidies to hydrocarbon producers well in excess of those we provide to wind, solar, and nuclear innovators. 

I shall leave for a future column how the demand-pull inflationary pressures resulting from a physical and a social infrastructure bill may interact with our current cost-push and wage-push inflation. It is possible to get this right and expand the capacity of the economy in a way that allows growth without inflation. It requires the coordination of both the supply and demand side of the economy. Well designed and coordinated monetary and fiscal policy can do this, but we won't do it with mere sloganism. 

It’s time for us to bite the bullet, control inflation, stimulate the COVID economy, and transition quickly to zero-carbon energy. It’s time to view our economy in the medium to long term, not in whatever is easiest and hence politically opportunistic in the short term. What do you wager whether we will get that one right?