The Great Inflation Peak

The years between the first and second oil shocks — roughly 1976 through early 1978 — occupy an uncomfortable place in economic memory. Inflation was running around 5 to 7 percent. Unemployment was falling from its 9% peak. The economy was growing. To a generation that had just survived 12% CPI and gas lines, a 6% inflation rate felt like progress.

It wasn't. A 6% inflation rate means prices double every twelve years. It means savers lose half their purchasing power in a decade. It means that anyone on a fixed income — retirees, pensioners, bondholders — is being slowly impoverished. And critically, it means that inflation expectations remain unanchored. Workers demand cost-of-living adjustments. Businesses raise prices in anticipation of rising costs. The wage-price spiral that had started in the late 1960s was still spinning, just more quietly.

The Consumer Price Index tells the story. From a post-recession low of about 5% in late 1976, CPI drifted up to 6.7% by mid-1977, then to 9% by the end of 1978. Each year was slightly worse than the last. And then, in January 1979, the Shah of Iran fled Tehran, and everything that had been smoldering caught fire.

In March 1978, President Carter appointed G. William Miller as Chairman of the Federal Reserve. It was, by broad consensus, the worst appointment to that office in modern history.

Miller came from Textron, a conglomerate, with no background in monetary economics. He viewed inflation as primarily a cost-push problem — caused by oil prices and union wages, not by money creation — and accordingly saw little role for interest rate policy in fighting it. During his seventeen months as chairman, the Fed raised rates only incrementally while inflation accelerated sharply.

The numbers bear this out. When Miller took office, CPI was at 6.8% and the Fed Funds rate stood at 6.79% — essentially zero in real terms. Over the course of 1978, CPI climbed to 9.0%, while the Fed Funds rate crept to 10.03%. The Fed was tightening, but always behind the curve. Real interest rates — the difference between Fed Funds and inflation — hovered near zero or negative throughout Miller's tenure. The signal to markets was clear: the Federal Reserve was not serious about inflation.

The dollar collapsed. Against the German mark, the Swiss franc, and the Japanese yen, the dollar fell 15-20% during 1978. Foreign central bankers openly questioned American monetary credibility. In November, the Carter administration was forced to mount an emergency dollar defense — raising rates, selling gold reserves, and drawing on IMF lines. It stabilized the currency temporarily, but the underlying problem remained: a central bank that wouldn't inflict pain.

On January 16, 1979, Shah Mohammad Reza Pahlavi fled Iran. The Iranian Revolution removed approximately five million barrels per day of oil production from world markets — about 7% of global supply. It was less severe than the 1973 OPEC embargo in absolute terms, but it hit an economy that was already running at 9% inflation with unanchored expectations.

The gasoline CPI index, which had been relatively stable around 50-55 through 1978, began an ascent that would take it from 55.2 in January 1979 to 98.0 by March 1980 — a 77.5% increase in fourteen months. Gas lines returned to American cities. Fistfights broke out at gas stations. In June 1979, the average price of regular gasoline crossed $1.00 per gallon for the first time in history.

The oil price shock rippled through the entire economy. The PPI All Commodities index, which tracks wholesale prices across raw materials and finished goods, surged from 72.7 in December 1978 to 93.8 by December 1980 — a 29% increase in two years. Unlike the first oil shock, which had hit a relatively localized set of energy prices, the second shock found an economy where inflation expectations were already elevated. Every price increase was immediately passed through to wages, which were immediately passed through to prices. The spiral was feeding on itself.

CPI crossed 10% in March 1979 and kept climbing: 11.1% by June, 11.9% by September, 13.3% by December. By early 1980, it would reach 14.6% — the highest rate since the post-World War II surge of 1947, and the highest rate that the modern, peacetime American economy had ever recorded.

By mid-1979, Carter knew the Miller experiment had failed. Inflation was approaching 12%. The dollar was in crisis. Carter's approval rating had fallen to 28%. On July 15, he delivered his famous "Crisis of Confidence" address — later known as the "malaise speech" — in which he spoke of a spiritual crisis gripping the nation. Two days later, he asked his entire cabinet to resign.

Miller was moved to Treasury. In his place, Carter appointed Paul Volcker, the president of the Federal Reserve Bank of New York. Volcker was six feet seven inches tall, chain-smoked cheap cigars, and had a reputation as the most hawkish monetary official in Washington. His appointment was a signal that the era of accommodation was over.

Volcker moved quickly. On October 6, 1979 — a Saturday — he called an extraordinary press conference and announced a fundamental change in Federal Reserve operating procedures. Instead of targeting a specific interest rate, the Fed would now target the growth rate of the money supply. Interest rates would be free to rise to whatever level was necessary to achieve monetary targets.

The effect was immediate and explosive. The Fed Funds rate jumped from 11.43% in September to 13.77% in October — a 234-basis-point increase in a single month. By year-end, it was 13.78%. The message was unmistakable: the new chairman would accept whatever interest rate the market demanded, however painful the consequences.

The initial Volcker shock did not immediately kill inflation. CPI continued climbing — from 13.3% in December 1979 to 14.6% in March 1980, its ultimate peak. The inflation had so much momentum that even 14% interest rates couldn't stop it within a few months.

In March 1980, with inflation seemingly out of control, President Carter invoked the Credit Control Act of 1969, authorizing the Federal Reserve to impose direct restrictions on consumer lending. The Fed enacted credit controls on March 14, targeting credit card lending and other forms of consumer credit. It was, in spirit, a return to the Nixon approach — administrative controls to do what monetary policy was struggling to achieve.

The response was swift and devastating. American consumers, interpreting the controls as a patriotic call to stop borrowing, slashed spending virtually overnight. Consumer credit outstanding fell at an annualized rate of 12%. Retail sales plunged. The Fed Funds rate spiked to 17.61% in April. The economy fell into recession — the second in five years.

But the 1980 recession was peculiar. It was sharp but brief — just six months, from January to July. Unemployment jumped from 6.3% to 7.8%, industrial production dropped from 52.1 to 48.6, and then it was over. The credit controls were lifted in July. Consumers, having been told to stop borrowing, now rushed to catch up. The economy snapped back. By October, industrial production was already recovering.

The problem was that the recession didn't cure the inflation. CPI fell from its 14.6% peak to about 12.5% by the end of 1980 — a two-point reduction that had cost a recession, soaring unemployment, and Carter's presidency (he lost to Reagan in November). The credit controls had been a political and economic disaster. And by late 1980, with the economy rebounding, inflation was threatening to accelerate again.

Volcker understood what Burns and Miller had not: this inflation could not be killed with one quick recession. The expectations were too deeply embedded. The wage-price contracts were too entrenched. The credibility of the Federal Reserve was too damaged. What was needed was a sustained period of punishing interest rates — not months, but years — to finally break the back of inflation expectations.

In December 1980, he pushed the Fed Funds rate to 18.9%. In January 1981, it reached 19.08%. The decisive battle — Volcker's War — was about to begin. That is the subject of Episode 6.

A 5-7% inflation rate is not "under control" — it is a slow emergency. The years 1976-78 felt like recovery. Inflation had come down from 12%. The economy was growing. But 6% inflation compounds devastatingly over time, and it keeps expectations unanchored. When the second oil shock hit, there was no buffer. CPI went from 6% to 14% in two years because the foundations of price stability had never been rebuilt. The lesson: don't confuse lower inflation with low inflation.

Central bank credibility is a real, measurable economic variable. Under Miller, the Fed raised rates from 6.8% to 10%. Under Volcker, the Fed raised rates from 10.9% to 13.8% in a single month. The total increase under Miller was larger, but the market impact was far smaller, because nobody believed Miller was committed. Volcker's Saturday Night Special worked not just because of the rate increase, but because it was accompanied by a radical change in operating procedure that made the commitment credible. The action and the signal together mattered more than either alone.

Administrative controls — price controls, credit controls — consistently fail. Nixon's price controls in 1971 delayed inflation and concentrated its arrival. Carter's credit controls in 1980 triggered a recession without curing inflation. In both cases, the controls created the illusion of progress while doing nothing about the underlying monetary excess. The American experience of the 1970s is the most extensively documented case study in the world for why governments should use monetary and fiscal tools rather than administrative controls to manage inflation.