Joblessness in the U.S. has fallen to its lowest level in more than a decade, yet wages and inflation have been slow to respond. It’s a puzzle for the Federal Reserve, and history may prove a relevant guide.
The Fed grappled with a similar situation in the 1960s, Deutsche Bank economists point out in a new research note. The unemployment rate fell from 7 percent in early 1961 to 4 percent by the end of 1965, yet core inflation was stuck in low gear — much like today.
Back in the ’60s, a confluence of fiscal and monetary policy factors caused prices to take off around the middle of the decade, starting an upward spiral that lasted into the 1970s and was eventually dubbed the “Great Inflation.” Many at the Fed see the episode as evidence of a major monetary policy mistake, so it’s noteworthy that several facets of today’s fiscal and economic landscape parallel that era.
Below, in charts, are the similarities and difference that Deutsche Bank sees between the 1960s experience and a half-century later.
Similar: low core inflation
The Fed is trying to achieve its dual goals — maximum employment and stable price gains near 2 percent. As the chart below shows, headline and core prices are moving up only slowly today, echoing the low-inflation early 1960s.
Similar: Low unemployment
In both episodes, tepid inflation occurred against a backdrop of low and falling unemployment.
Back then, joblessness ultimately fell enough to help trigger higher wages and prices, a relationship described by what economists call the Phillips Curve.
Today, “even though we agree that the Phillips curve is flat, it is not dead,” Matthew Luzzetti, Peter Hooper and their co-authors write. Reaching the threshold where low joblessness will push up wages and inflation more quickly “likely requires at least another 0.5 percentage point decline in the unemployment rate.”
Similar: Medical cost inflation at a crossroads
Back in 1960, a couple of fiscal policy changes helped to kick price gains into high gear. The advent of Medicare and Medicaid played a major role, greatly expanding access to medical care for the poor and elderly.
As more people gained access to a limited supply of medical services, medical-care inflation climbed rapidly at a time when food, shelter and apparel prices were also rising, albeit less aggressively. The shock might have helped to jolt firms and households out of their long-held expectation for slow price gains.
That history “is of some relevance to the current period” because the Affordable Care Act seems to have held down health-care inflation in recent years, and now some aspects of it look to be on Congress’s chopping block, creating “the potential for a reversal if significant elements of that act are repealed.”
Different: Labor force growth
The 1960s isn’t a perfect parallel to today’s situation, in part because the labor market has changed dramatically. Back then, women were coming into the workforce, driving participation higher. Today, the share of the population that participates in the job market is in the middle of a long-run decline.
That matters, because slower labor-force growth together with lower productivity means that the economy’s potential growth rate has declined. A lower potential growth rate means that the neutral federal funds rate — the interest rate setting that the central bank can implement if it wants to neither stoke nor slow the economy — is a lot lower these days. As a result, even though the Fed’s rate setting looks low today by historical standards, it’s actually not all that accommodative, reducing the chance of a policy error.
Different: Scope of fiscal policy, Fed mindset
It goes without saying that most economists aren’t expecting fiscal policy over the next year to resemble the “Great Society” programs of the 1960s, which sought to battle poverty and expand prosperity by dramatically changing America’s social safety net. Likewise, Fed officials today are hyper-aware that getting behind the curve can result in runaway price gains: evidenced when they lifted rates in June, at a time when their preferred price measure actually showed some deterioration in inflation.
“We do not anticipate a demand shock as large as the ’60s, nor do we expect the Fed to commit the same policy mistake,” the report authors write. Still, “the policy triggers that supported the increase in inflation expectations in the 1960s are plausible in the next 12 months (albeit in smaller scale and scope).”