SERIOUS MONEY:INVESTORS HAVE hardly paused for breath before replacing concerns that the credit crisis might lead to another Great Depression with fears that easy monetary policy alongside surging commodity prices might see a return of the Great Inflation.

The jump in the University of Michigan's consumer survey of one-year inflation expectations to a 26-year high, combined with the unrelenting rise in oil prices, has caused some to argue that a replay of the 1970s is in store.

But is the US's only peacetime inflation bubble really set to return? Revisiting the 1960s and 1970s may help decide. The US was haunted by memories of the Great Depression in the aftermath of the second World War and pursued inflationary policies through the 1950s and 1960s.

This did not immediately produce a pronounced decline in the dollar's purchasing power, because US president Dwight D Eisenhower was a notable inflation hawk and oversaw recessions in 1953, 1957 and 1960.

The modest growth under Eisenhower, however, allowed John F Kennedy to win the 1960 election on the promise to "get the economy moving again", and neo-Keynesian economics came to dominate policy in Washington.

Kennedy's deficit spending was continued under Lyndon B Johnson following the former's assassination, and the "new economics" proved successful in the short-term. But the administration failed to recognise that this was simply a function of the economic slack that arose during the Eisenhower years.

Johnson, encouraged by the policy's early success, decided in the mid-1960s to fight both the escalating war in Vietnam and his war on poverty without an increase in tax rates, even though the economy was no longer operating below potential.

His decision contributed to an oversupply of dollars and a seemingly unstoppable acceleration in the rate of inflation. That motivated unionised workers to act. Roughly a quarter of the labour force was unionised in the 1960s and the unions' power allowed them to secure cost-of-living adjustments, precipitating a wage-price spiral.

Economic mismanagement also placed considerable downward pressure on the dollar, and the fixed exchange rate regime that had persisted since the second World War broke in 1971 when US president Richard Nixon relinquished the greenback's link to gold. The resulting fall in the dollar caused oil-producing countries to seek compensation through higher prices - restoring the purchasing power of oil to pre-devaluation levels.

The US Federal Reserve pursued a misguided policy of deficit monetisation in response to the oil shock, which served to intensify inflationary pressures. The purchase of interest-bearing government debt in exchange for high-powered money led to a surge in the supply of dollars.

The series of policy mistakes saw inflation jump from below 2 per cent in the mid-1960s to double-digit levels a decade later, yet no one seemed to have the stomach to apply the necessary medicine until Paul Volcker's arrival at the Fed in 1979.

Comparisons between the 1970s and now are easy to make, given the surging input costs common to both periods.

However, the notion that current circumstances will lead to a sustained upward surge in inflation expectations is naive.

There is no evidence of a wage-price spiral, and the emergence of such is not likely given that employees' bargaining power has been substantially reduced by the more than one percentage point increase in the unemployment rate from its cycle low registered 15 months ago.

Furthermore, unionised workers account for about 10 per cent of the labour force, considerably lower than in the 1960s, while globalisation has placed a ceiling on wage growth.

Indeed, the year-on-year increase in the employment cost index peaked in 2003, despite a tighter labour market. There are few signs that the manufacturing industry has been able to raise final goods prices by enough to compensate for rising input costs, and pricing power is sure to deteriorate, given the over two percentage point drop in capacity utilisation since last summer.

Rising input costs are likely to result in margin compression rather than increased final goods prices. Indeed, the year-on-year increase in core inflation has already dropped by half a percentage point from its cycle high registered last September.

Fed policy is not inflationary today, unlike the ill-conceived deficit monetisation of the 1960s, and Irving Fisher's quantity theory of money shows why.

Nominal gross domestic product growth is a function of changes in the money stock and in its velocity, ie the rate at which it circulates through the economy.

M2 is a measure of total money supply. M2 growth has decelerated markedly in recent weeks, as evidenced by the drop in the annualised 13-week rate of growth from double-digit levels in April to below 3 per cent recently.

M2 velocity has been on a downward trend for seven consecutive quarters and is declining at an annual rate of 1 per cent. The trend is likely to persist since households can no longer convert asset gains to cash at will. Indeed, mortgage equity withdrawals have collapsed, as have corporate share repurchases.

Combined with modest growth in M2, real output growth will remain sluggish at best, while the inflation rate will moderate.

The idea that inflation is set for take-off is ludicrous. The financial system remains fragile. Households face myriad challenges, including labour market uncertainty.

The corporate sector is in the midst of an earnings recession. The outlook for stock prices remains poor, but the culprit is the weak economy and not 1970s-style inflation.

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