How did we come to believe the Fed has to plunge us into recession to kill inflation? Lowering inflation to 2 percent, posits a recent IMF study, may require a 6.5 percent unemployment rate over a few years. Economist Larry Summers says we need 5 percent unemployment rate for five years. 

People attempt to understand inflation relative to the Great Inflation between 1965 and 1981, even though today’s macro backdrop is starkly different. Lyndon B. Johnson unleashed a torrent of federal spending after the jobless rate had fallen to 4 percent, which economists at the time considered to be full employment.

“From a macroeconomic policy perspective, it would have been a logical moment to ease up on the accelerator,” writes Ben Bernanke in his book 21st Century Monetary Policy: The Federal Reserve from the Great Inflation to COVID-19, “but foreign policy and social goals took priority over economic stability.”

Defense spending rose about 44 percent between 1965 and 1968 as America plunged more deeply into the war in Vietnam. President Johnson launched both his war on poverty and the Great Society programs, including Medicare and Medicaid. Inflation rose from 1.2 percent in 1964 to 5.9 percent in 1969. 

Source: History

The Fed tightened policy in 1969, causing a mild recession in the following year, but inflation never fell below 3 percent. The demise of the Bretton Woods system in 1971 is the next chapter in the story. After the US dollar’s connection to gold was severed, it lost 70 percent of its value, which accelerated the inflationary cycle.

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