14 - Can the Inflation of the 1970s be Explained?

Summary

By many standards inflation has been a “surprise” during the past six years. Errors in forecasting inflation have increased markedly compared with earlier periods. For instance, during the interval 1971:3 to 1975:4 the root mean-square error of the Livingston panel of economists in forecasting the consumer price index six months ahead was 3.5 percentage points at an annual rate, compared with an error of 1.6 percentage points over the previous seventeen years. Not only did the panel forecasters fail to predict the increased variance of the inflation rate in the 1970s, but also they fell far short in predicting the cumulative total price change between 1971 and 1976 – 24 percent compared with the actual change of 34 percent. Most of the error occurred during the four quarters of 1974, with an actual increase of 11.6 percent, almost twice the 6 percent increase forecast six months in advance.

In searching for an explanation for this inflation, this paper can be likened to an investigative report following a railroad or airline crash. The news of the disaster – in this case, the failure to forecast inflation accurately – was reported long ago and by now is well known. But what can we say beyond the fact that the disaster occurred? Just as transportation investigations attempt to determine which specific parts of the machine failed, and to recommend improvements, so here the relationship of the inflation rate to other important economic variables is studied to determine as precisely as possible what was different about the experience of the 1970s, and what lessons can be learned from past mistakes.