The History of Prices and Inflation in the U.S.

Numerous proposals over the past few years have called for increased congressional oversight of the Federal Reserve’s monetary policymaking. One reason often cited: the significant increase in the U.S. price level since the Fed was established in 1913.

In an article published in The Regional Economist, Senior Economist Fernando Martin provided some historical context. He revisited some basic facts about prices and inflation since the founding of the U.S., including after the creation of the Fed.

Price Levels Since 1790

Martin used two data series to measure price levels since 1790:

• The gross domestic product (GDP) deflator
• The consumer price index (CPI)¹

He noted that both measures paint a similar overall picture, including the existence of at least two different “eras” characterizing the behavior of prices:

• From the founding of the U.S. until the establishment of the Fed and the start of World War I
• From around World War II through the present day

“Overall, prices seem to move around a stable average during the pre-Fed era, while they have increased steadily since World War II,” he wrote.

Inflation Since the Late 1790s

Martin then looked at the changes in prices rather than their levels over time, using inflation measured by the yearly increase in the GDP deflator. (For a figure showing inflation since the U.S.’s founding, see the article “A Short History of Prices, Inflation since the Founding of the U.S.”)

“Before World War II, episodes of high inflation were followed by periods of deflation, which explains the fact that the price level moved around a stable average,” Martin said.

He noted that the inflationary episodes coincided with the convertibility of the dollar to gold and/or silver being suspended to meet the demand for additional government revenue. Examples include the Civil War and World War I.

When convertibility was reinstated and prices returned to their prewar levels, deflationary periods followed. “Although the price level was stable over the long run, inflation was very volatile during this period,” he said.

Ending Inflation Volatility

Martin highlighted two important inflationary episodes that explain a significant share of the price increases since World War II:

• The war itself (as inflation rose during the war) and the need to partly pay for the public debt that had accumulated to finance it²
• The 1970s, when stagflation—a combination of high inflation and low output growth—emerged due to external oil shocks and incorrect or misguided monetary policy

“High inflation was effectively defeated during Paul Volcker’s tenure as Fed chairman (1979-1987), and inflation has remained low and stable since,” he said.

The Role of Ending Gold and Silver Convertibility

While the post-World War II period exhibits the same recurrence of high inflation episodes as the preceding period, Martin noted that the lack of adherence to a metal-backed monetary system made the price level increase permanent rather than transitory. As a result, inflation volatility decreased significantly in the postwar period.

“In other words, with the joint creation of the Fed and the abandonment of metal convertibility of the currency, the economy traded off higher inflation for more stable inflation,” Martin said.

Higher Inflation Vs. More-Stable Inflation

Martin explained that higher inflation is generally considered bad (since it taxes nominal asset holdings and cash transactions), while more-stable inflation is generally considered good (since it makes the future easier to predict). The latter leads to more-efficient economic decisions, lower costs of long-term (nominal) contracts and increased stability of the financial system.

He further explained that eliminating the need for deflation avoids having to endure the potentially costly and gradual process of price and wage reduction. He added that many households get hurt by deflation since the real burden of their debt (such as mortgage payments with a fixed-interest rate) increases as prices and nominal wages fall.

In summary, “Episodes of high inflation, which carry high economic costs, are nothing new and instead a recurrent feature in U.S. history,” Martin said. “In this regard, the important difference between the pre-Fed and the postwar eras is that these high-inflation episodes were previously followed by prolonged deflation and, in the more recent era, by a return to normal (and positive) inflation rates.”

Notes and References

¹ Data for the GDP deflator until 1928 are taken from Johnston, Louis; and Williamson, Samuel H. “What Was the U.S. GDP Then?” Measuring Worth, 2017. Data on CPI until 1912 are taken from Lindert, Peter H.; and Sutch, Richard. “Consumer price indexes, for all items: 1774-2003,” Historical Statistics of the United States, Millennial Edition, New York, N.Y.: Cambridge University Press, 2006. All other data come from the Bureau of Economic Analysis and the Bureau of Labor Statistics.

² Ohanian, Lee E. The Macroeconomic Effects of War Finance in the United States: Taxes, Inflation, and Deficit Finance. New York, N.Y., and London: Garland Publishing, 1998.

Additional Resources

• Regional Economist: A Short History of Prices, Inflation since the Founding of the U.S.
• Timely Topics: The Gold Standard
• On the Economy: The Gold Standard and Price Inflation