Since around 1940, although at varying levels, we have become accustomed to inflation. Yet prior to 1940, we experienced about as much deflation (falling prices) as inflation. In fact, over the 75-year period of 1865 to 1940, prices on average decreased by 8.5 percent. For example, if this declining price-level trend had continued to the present day, that 15-cent McDonald's hamburger from 1955 would now cost about 14 cents.

So, what causes deflation? Weak demand relative to supply puts downward pressure on prices and wages. Hence, prolonged and/or deep recessions often cause deflation. Since 1955, we experienced deflation only once, during the “Great Recession,” at just 0.3 percent in 2009.

Before 1940, when deflation was common, our economy went through expansions/recessions for "natural" economic reasons. Since 1940, our economy has been managed at varying degrees by fiscal and monetary policies, sometimes successfully, sometimes not. (Fiscal policy is government spending/taxation, made by Congress at the federal level, while monetary policy is the Federal Reserve’s — the Fed’s — control of the money supply to influence items such as interest rates.)

Looking at that 1865 to 1940 period, the average economic expansion was just 25.2 months, while the average recession was nearly as long, at 22.1 months. In contrast, from 1945 to 2020, the average expansion was much higher at 64.3 months, while the average recession was much shorter at just 10.3 months. Hence, one reason that both the European Central Bank and the Fed target 2 percent inflation is to avoid this high cost of 0 percent inflation (having as much deflation as inflation, caused by more and/or longer recessions).

Where did the 1970s’ high inflation come from and how did it end?

Fiscal policy became expansionary by the mid- to late 1960s, in large part due to spending on the Vietnam War, along with some new spending for LBJ's Great Society Programs. In addition, monetary policy became quite expansionary as the Fed, trying to keep interest rates too low, created too much money.

Then, OPEC’s oil embargo during the 1973 Yom Kippur War quadrupled oil prices. This in effect reduced aggregate supply, which added to our already higher inflation, while decreasing output at the same time. Some of us remember this as “stagflation,” a term coined to describe this phenomenon. In 1974, inflation reached double digits for the first time in 27 years.

As inflation became more entrenched, inflation expectations began to rise, which in turn caused further inflation. Cost-of-living allowances, often associated with unionization, were more common then. Higher inflation expectations often led to higher wages, which helped to fuel a wage-price spiral. Additionally, higher expected inflation also led to higher interest rates. Inflation during 1973 to 1982 ranged from a low of 5.8 percent to a high of 13.5 percent.

How did this high inflation come to an end? The Fed sharply increased interest rates (30-year mortgage rates peaked at 18.6 percent), causing a severe recession in 1981 and 1982, with the unemployment rate climbing to 10.8 percent. This quickly brought inflation down to 3.2 percent by 1983, along with falling inflation expectations. Hence, the Fed gets credit for bringing inflation down, but also takes the blame for the 1981-1982 recession.

Why was inflation well behaved from the early 1980s until recently?

Inflation remained fairly well behaved until recently due to a number of supply-side effects. First, some developments helped keep a lid on prices, but on the other hand, came at the expense of lower wages for workers. Unionization in the private sector sharply declined, while the adjusted-for-inflation minimum wage, which reached an all-time high in 1968, fell to low levels. Restraints on competition, such as non-compete clauses, in the workforce became more common, and employers increasingly outsourced labor, which often came with lower pay/benefits.

Second, labor productivity increased in the 1990s as we learned to use computers more efficiently. Third, the peak year for baby boomer births was in 1957. Consequently, a record number of workers in the labor force were in their prime years in terms of experience, education and training.

Fourth, after doubling in 1979 during the Iranian Revolution, oil prices subsequently became relatively well behaved. (There was a short-lived oil price spike in 2008.) The OPEC Cartel, like many cartels, went through periods of members cheating on their production quotas while new non-OPEC sources of oil were developed. Both put downward pressure on oil prices. Finally, and maybe the supply-side effect with the largest impact, globalization led to an increase of more cheaply produced goods from abroad and made it more difficult for firms at home to raise prices.

Where did our current (2022) inflation come from?

The most significant factor came from negative supply-side effects. First, cracks in globalization began to appear about four or five years ago as trade tensions developed with China, including higher tariffs. Then, of course, a huge supply-side issue emerged in 2020 with the pandemic workplace disruptions that we are all too familiar with, such as some businesses temporarily shutting down and supply chain/bottleneck issues appearing, including in transportation.

These pandemic disruptions caused aggregate supply to shift back (recall what happened in the 1970s when oil prices shot up), causing world-wide inflation along with falling economic output. In addition, we now unfortunately have new supply-side issues coming from the Russian war in Ukraine. This has led to further increases in the price of oil, wheat and other commodities.

Meanwhile, during the pandemic, expansionary fiscal and monetary policy created very strong demand in the U.S. The pandemic fiscal policies passed in 2020 and 2021 totaled close to $6 trillion. Never in peacetime have we seen government spending on this gigantic scale.

In contrast, fiscal policy during the Great Recession (caused by a financial crisis, which typically results in longer/deeper recessions) was under $1 trillion, adjusted to 2020 prices. Many economists felt this was too little, as unemployment rates remained high, staying over 7 percent from late 2008 to late 2013.

Pandemic monetary policy was also very expansionary. Among other actions, the Fed decreased short-term interest rates to near zero, and the Fed's balance sheet increased from $4 trillion to $9 trillion via "quantitative easing” (the Fed buying long-term U.S. government bonds and mortgage-backed securities).

These expansionary fiscal/monetary policies initially served us well and shortened our recession; the 2020 recession was the shortest on record, lasting only two months. But some argue that this combined fiscal/monetary policy was too expansionary for too long and probably added about 2 percent to inflation by late 2021/early 2022. In March 2022, Fed Chairman Jerome Powell even stated that “hindsight says we should have moved earlier. But there really is no precedent for this.”

The outlook for inflation?

Running at its highest level since in 1981, inflation is currently at 8.3 percent (down slightly from 8.5 percent last month). Nonetheless, for a number of reasons, inflation should begin to fall and is expected to run at about 4 percent by year-end. As the pandemic evolves, supply-side disruptions should increasingly fade. In addition, expansionary fiscal policy has pretty much run its course, while the Fed started in March to increase interest rates at a pace not seen in over 20 years. The Fed also introduced a plan to decrease its balance sheet. Rising mortgage rates should help slow real estate price increases. Higher interest rates for other types of loans will slow other spending, such as for autos and business investment.

Yet, some inflationary concerns remain. Our very low unemployment rate (3.6 percent), exacerbated by demographic changes such as retiring baby boomers and lower labor force participation rates, will put upward pressure on wages. And, if inflation expectations take hold, this can add to a wage-price spiral. However, future immigration and potential development of labor-saving automation, such as self-driving vehicles, are two unknowns that could temper future wage increases.

In addition, we still face unknown negative supply-side effects from the Russian war in Ukraine and recent pandemic lockdowns in China.

Can the Fed achieve a “soft landing,” or decrease of inflation without causing a recession? While some economists are hopeful, Greg Ip recently wrote in the Wall Street Journal: “How many times since the Second World War has the Fed raised interest rates to lower the inflation rate without causing a recession? The answer is zero.”

If we do have a hard landing, I am hopeful that this next recession will be relatively short and shallow. Yet, some uncertainty still hangs over us due to unpredictable pandemic and war developments.

Dr. Robert Tokle is a professor of economics at Idaho State University’s College of Business.