Explainer: why is inflation so high and what happened the last time it reached this level?

Inflation remains the biggest economic concern for most Americans.

In July, the consumer price index rose by 8.5% compared to the same month a year earlier. While inflation was still high, it eased from its near-historic pace in June.

Eighty-two percent of Americans are concerned about the negative effect of inflation on the purchasing power of their income over the next six months, according to a recent study by Allianz Life. Furthermore, 71% said their income does not keep up with rising costs.

Here’s an explanation of why inflation is so high and what happened the last time prices rose so fast.

Why is inflation so high?

Like many economic problems, inflation amounts to an imbalance between supply and demand.

Hundreds of millions around the world affected by lockdowns replaced restaurant spending with banks and exercise bikes. The surge in demand followed a pandemic-induced flood of economic stimulus. In addition, that stimulus fueled a rapid economic recovery from the March 2020 recession, triggering a hiring blitz.

But the surge in demand for goods and labor far outstripped supply as COVID-related bottlenecks slowed delivery times and fears of infection kept workers on the sidelines.

In turn, prices and wages skyrocketed, leading to skyrocketing inflation. Such price hikes have confused countries around the world, some of which have suffered much higher inflation than in the US. In Argentina inflation is 64%; in Turkey it is almost 80%.

What is the government doing to lower prices?

The Federal Reserve has embarked on an aggressive series of rate hikes that raise the cost of borrowing. In theory, rate hikes should reduce demand, slow the economy and lower inflation.

In meetings over the past two months, the central bank has raised its benchmark rate by 0.75% — dramatic increases last matched in 1994. After a data release last week showed that July hiring far exceeded expectations, The Federal Reserve is widely expected to make another rate hike at its next meeting in September.

Meanwhile, Congress has taken measures that could reduce inflation in the long run.

On Sunday, the Senate passed the Inflation Reduction Act of 2022, which will bring in $739 billion in new revenue and put at least $300 billion toward deficit reduction.

If passed into law, the bill would increase inflation very slightly over the next two years, but would reduce inflation by the end of the 2020s, the report said. a study from the Wharton School of Business at the University of Pennsylvania who looked at an early draft of the bill.

When did inflation last reach this level and how was it resolved?

The last time inflation was this high was in 1981. Back then, high prices combined with a weak economy caused financial woes for many Americans.

The dynamics put central bankers in a difficult position. If they raised interest rates and slowed the economy, it could push the economy into recession, causing more pain. But cutting interest rates would stimulate the economy and potentially push inflation up even further.

Paul Volcker, who took over as chairman of the Fed in 1979, vowed to raise interest rates until inflation was under control — no matter how much the economy slowed. The short-term economic pain far outweighed the long-term damage from inflation, Volcker argued.

In 1981, the Fed’s benchmark interest rate rose to 20%. By comparison, after several rate hikes this year to tackle inflation, rates are still in a range of 2.25% to 2.50%.

In 1981, those high interest rates helped push the US into recession and push the unemployment rate above 10%. By comparison, today’s unemployment rate corresponds to a 50-year low reached just before the start of the pandemic in 2020.

But Volcker’s aggressive approach did push inflation down. When Volcker left the position in August 1987, inflation had fallen to 3.4% from its peak of 9.8% in 1981.

Powell, the current Fed chairman, has vowed to cut inflation. He said last month that the central bank expects additional rate hikes to be needed to bring inflation back to its target of 2%.

But, as in the early 1980s, a Fed-induced economic slowdown could cause pain in the short term before inflation levels off. Or, if the central bank achieves what economists call a “soft landing,” the central bank can lower inflation and avoid a recession.