Fear of Soaring

The economy had begun overheating in the 1960s, when President Lyndon B. Johnson presided over a tax cut, then raised spending on both Great Society social programs and the Vietnam War. By 1971, President Richard M. Nixon was so alarmed about inflation that he imposed wage and price controls, which merely suppressed price pressures. The 1973 oil embargo and 1978 Iranian revolution drove up oil prices. Automatic pay increases linked to inflation helped feed "wage-price spirals."

Despite these inflation pressures, the Fed never tightened policy enough during this time to bring inflation down again to its pre-1965 level. Indeed the Fed eased at times to counter the recessions' effects, pouring extra fuel on the inflation fire. Even when short-term rates in the double digits appeared to be very high, they were really extremely low, after adjusting for inflation.

Many economists believe the inflation pressures alone could not have created long-term overall price inflation if the Fed hadn't provided the fuel in the form of easy money, or low interest rates. Cut off the fuel, or "accommodation" in Fed parlance, and you snuff out the fire. Without Fed accommodation, increases in the prices of some items would just force households and businesses to spend less on others.

Economist do debate why the Fed made such mistakes. Some have argued that policymakers then labored under several misconceptions about how the economy and monetary policy worked, noting that they had no experience with peacetime inflation. Others say the problem was the lack of political support until 1979 for the painful policies required.

Current Fed Governor Ben S. Bernanke is among the economists who argue that the Fed's mistakes during that decade made matters worse by sending inflation expectations out of control.

"The problem arises from the fact that, if policymakers do not react sufficiently aggressively to increases in inflation, spontaneously arising expectations of increased inflation can ultimately be self-confirming and even self-reinforcing," he said earlier this year, in a speech laying out some of the thinking on what went wrong in the '70s and what has gone right since.

This is one reason Fed officials today are concerned about how consumers will react to rising prices and interest rates.

"Expectations that prices will go up make people more willing to pay more," said Joseph Sirgy, a consumer psychologist at Virginia Polytechnic and State University.

Consumers' responses to price changes depend largely on their expectations, which vary depending on experience. For example, Sirgy said, consumers have come to expect prices on electronics to fall over time, making some unwilling to pay the initial prices for the newest gadgets, preferring to wait until they drop a bit.

This means younger people may have a harder time adjusting to the changing economic environment, said Sirgy and others who have studied consumer behavior. Younger people tend to have higher and more unrealistic expectations about life in general than their elders, making them more prone to disappointment. Older people consistently describe themselves as more satisfied than younger people, in part because they have lowered their expectations to bring them more in line with reality.