The New York Times
November 6, 1997
By PETER PASSELL
An economic report from Washington last week could hardly have brought cheerier news to investors shaken by turmoil in Asia. In spite of brisk economic growth, the government's most comprehensive measure of inflation rose at the slowest pace since 1964. Strikingly, though, not all the interpretations of the data are sanguine.
Some analysts suggest that the report, covering the third quarter of the year, really amounts to a last hurrah for the inflation-resistant economy that drove the stock market to record highs. "Inflation has been camouflaged by manna from heaven," argued Robert Gordon, a widely respected economist at Northwestern University whose research focuses on the links between growth and prices.
Depending on who's talking, everything from a strong dollar and stable health costs to changes in the way the price index is put together have conspired to keep inflation in check. And at least in the view of Gordon, "one-time factors can't protect price stability much longer."
On first impression, the latest numbers seem guaranteed to smooth the brows of anxious policy-makers and investors. Solid gains in exports, business investment and personal consumption powered the U.S. economy to a 3.5 percent annual growth rate in the third quarter, a full percentage point more than mainstream economists have contended is sustainable without creating shortages and bottlenecks in production.
Meanwhile, the price index for domestic output as a whole -- the "deflator" for the gross domestic product -- rose at an annual rate of just 1.4 percent, the lowest in 33 years. And if food and energy (traditionally volatile components of the index) are excluded, prices rose by a mere 1 percent.
This combination of strong growth and stable prices is no surprise to converts to the "new paradigm," people who believe that tightening markets for labor need not cause a wage and price spiral in an era of weak labor unions, productivity-obsessed corporate executives and fierce competition from imports. Indeed, the buzzword of the moment on Wall Street is deflation.
Many market analysts, reacting to economic stagnation in Japan, competitive currency devaluations in Southeast Asia and a worldwide glut in manufacturing capacity in autos, petrochemicals and electronics, have decided that inflation is a bugaboo of the past.
"We're in a new world of flexible prices" in which markets react quickly and decisively to the gap between supply and demand, concluded Bruce Steinberg, an economist at Merrill Lynch.
Or maybe not. Barry Bosworth, an economist at the Brookings Institution, sees the decline in inflation as "transitory." Profit margins have been exceptionally high, he explains, thanks to unanticipated cost savings and unexpectedly strong sales. But corporations flush with cash have now set their sights on increasing market share, generating a hiatus from upward pressure on prices.
For this pause to endure, output per hour would have to grow at least as rapidly as wages. And while "predictions of a productivity revolution in the making have been around since the 1980s, I don't see any evidence of long-term gains," Bosworth said.
William Dudley, chief U.S. economist at Goldman, Sachs, buttresses this view. Medical care consumes one dollar out of eight spent in the United States. And after a decade of rapid increases, medical-insurance premiums have recently been growing at roughly the cost of living, giving business a breather on outlays for fringe benefits.
But the era of stable medical costs "looks like it's ending," Dudley argued. Profits at health-maintenance organizations have fallen through the floor: Aetna and Cigna recently reported losses, while Oxford Health Plans, which had been considered the industry model, just took hundreds of millions of dollars in write-offs. Not surprisingly, health insurers are now hinting broadly at big premium increases down the road.
By the same token, price stability has gotten help from the rising dollar, which discouraged U.S. businesses from raising prices for fear of losing sales to imports. Now, depreciation of the Southeast Asian currencies and a glut in manufacturing capacity in the region could mean more of the same.
But Dudley suggests that the inflation-tempering impact of deflation in Southeast Asia will be offset by currency appreciation elsewhere. The weakening of the dollar against the yen, mark and pound gives U.S. producers some room to raise prices in markets still dominated by European and Japanese corporations.
While Bosworth and Dudley discount signs that the inflation trend is improving, Gordon of Northwestern has a far grimmer story to tell. For starters, Gordon estimates that purely technical changes in the way the Bureau of Labor Statistics has assayed prices in the last few years have cut the measured rate of inflation by half a percentage point. This is a one-time change, and thus won't help to dampen measured inflation in the future.
More important, he suggests, the benefits from falling computer prices have been exaggerated. Statisticians have long wrestled with the problem of measuring deflation in this industry, where quality is improving rapidly and new products are frequently introduced.
For example, if today's basic desktop PC, a 200-megahertz Pentium machine with 2-gigabyte hard drive, 16 megabytes of memory and a super-speed CD-ROM, cost 20 percent less than a 120-megahertz machine with a 486 processor, a 600-megabyte hard drive and 8 megabytes of memory did in 1995, how much has the price of computers declined?
In the past, Washington calculated annual price declines of about 10 percent, which many experts considered too low. The latest figures show computer prices falling at nearly 30 percent annually, and Gordon argues the pendulum has swung the other way. If he is right, a mere return to a long-term trend rate of 15 percent to 20 percent would show in the price index as an up tick in inflation.
The exhaustion of Gordon's "manna from heaven" could spell big trouble ahead. Economists generally hold that when unemployment falls below a certain level, competition for workers will begin to push up wages and prices.
Gordon estimates that the combined impact of favorable but temporary factors lowered this level of unemployment consistent with price stability by a full percentage point. Thus, while economists have recently been inclined to believe that 5 percent unemployment is consistent with stable prices, the Gordon analysis implies that the magic number is closer to 6 percent.
There is no evidence that the Federal Reserve Board has reached the same conclusion. If Gordon's message does gets through, though, it could bring a pre-emptive strike in the form of an increase in interest rates this winter.
And even if the Fed is reluctant to act in the midst of currency and securities-market crises in far-flung corners of the world, it will have a fine excuse to tighten monetary policy on the likely news of an up tick in measured inflation in coming months. "Rising medical-care costs led to Fed tightening in the late 1980s -- and to the recession of 1990," Gordon notes.
Copyright 1997 The New York Times Company