August 22, 1999
ECONOMIC VIEW
Inflation Just Doesn't Add Up
Related Article
Issue in Depth: Federal Reserve
By SYLVIA NASAR
arely a year after a worldwide deflation scare -- when markets
and currencies were crashing, banks and businesses in Asia, Russia
and Latin America were failing, and prices of oil and raw materials
were plunging -- inflation is back on peoples' minds.
On the face of it, fretting about inflation when every major
price gauge in the United States is rising just 2 percent or so a
year seems a little like Uma Thurman obsessing over her weight. But
what concerns Alan Greenspan, the Federal Reserve chairman, and
Wall Street investors is the nagging suspicion that the stellar
inflation record of the last two years was mostly the product of a
few lucky, highly transitory breaks -- and therefore won't last.
That suspicion is likely to propel the Fed's policy-making
committee toward another interest-rate increase when it meets on
Tuesday.
Admittedly, the budding recovery in Asia and Europe has already
blunted some of the forces that have helped push U.S. inflation
down from 4 percent to 2 percent a year since 1997. Energy prices --
indeed, most commodity prices other than farm products -- are
already rebounding sharply after collapsing last year. And the
high-flying dollar, which helped to make imports cheaper, has
recently weakened against the euro and the yen as global investors
have begun to shift some of their mutual fund money away from the
United States to foreign markets.
Sounds dire, right? Actually, there are solid reasons for
thinking that a return to the bad old days, when upwardly spiraling
prices seemed as inevitable as the sunrise, is highly unlikely. For
one thing, some of those "transitory" factors are likely to
persist for quite a while longer. For another, popular expectations
about inflation -- low inflation, this time -- readily become
self-fulfilling prophecies. And a host of structural and policy
changes over the last couple of decades have made the U.S. economy
less inherently prone to inflation.
Even skeptics now say that the low inflation of the 1990s is not
just a fluke, but rather a return to a norm that prevailed for a
quarter-century, beginning in the late 1940s -- years when 4 percent
inflation seemed scandalously high. As Alan S. Blinder, an
economist at Princeton University and former vice chairman of the
Federal Reserve, said recently, "To a substantial extent, we're
back to the '50s."
Jeffrey Frankel of Harvard University, until recently a member
of the President's Council of Economic Advisers, said of mainstream
economists: "A lot of us were real stick-in-the-muds. We said:
'No, no, no. Here are the equations.' But other people who knew
less about equations had the sense to realize that things are a bit
different."
For starters, not all the good luck is evaporating. True, energy
prices have jumped 24 percent since the beginning of the year. But
energy wasn't a big factor in inflation's decline -- the economy
uses a lot less energy than it did in, say, 1973 -- and this year's
price increase isn't anything like the surges in 1973 or 1990. Most
of the impact has already filtered through to consumer prices for
gasoline, electricity, heating oil and air fares, adding at most a
few tenths of a percentage point to the inflation rate.
The dollar's recent dip and the ballooning trade deficit have
some economists, notably Paul Krugman of the Massachusetts
Institute of Technology, warning of the possibility of a currency
crisis. If the dollar were to take a big dive, that would indeed
threaten to push inflation up sharply. But it would also provoke a
sharp reaction from the Fed. And the dollar is still slightly
stronger on a trade-weighted basis (that is, against a basket of
currencies of America's trading partners) than it was at the start
of the year.
More to the point, import prices, by far the biggest recent drag
on inflation, are apt to remain under downward pressure. Their
decline, it turns out, was due less to the strong dollar than to
vast excess productive capacity in Asia, Latin America and
elsewhere -- an excess that will not be mopped up soon, given the
gradual pace of world recovery. "It's not just the dollar, but
economic incentives to increase production abroad," said Robert J.
Gordon, an economist at Northwestern University.
Domestically, health care costs have stopped skyrocketing and
show few signs of resuming that course, despite increases over the
last year in the fees that health maintenance organizations charge
employers. Though the latest readings show consumer prices for
medical care rising a bit faster than a year ago, few experts
expect the pace to accelerate to twice the overall inflation rate,
as it did in the early 1990s.
In any case, even temporary lulls in inflation can have
long-term effects, by changing expectations. Americans who believed
two decades ago that inflation would always rise are now expecting
it to remain low. According to the monthly University of Michigan
survey of consumer expectations, ordinary Americans expect the
inflation rate a year from now to be under 3 percent. (The Federal
Reserve forecasts 2.5 percent or less.) "You get this extra
impact," Gordon said. "The biggest factor holding down inflation
in the next couple of years is the lower inflation of the past
couple."
But perhaps the strongest reasons for optimism are sweeping
changes in the economy that have been in the works for years.
Back in the bad old 1970s, temporary supply shocks tended to
produce higher inflation automatically. Since then, some long-term
trends -- globalization, deregulation, the computer revolution --
have made the economy less susceptible to bottlenecks and
wage-price spirals. "One story is that we are permanently able to
run the economy hotter and labor markets tighter," Krugman said,
"because we have a more flexible labor market, and monopoly and
union power have been curbed by international competition."
Consider deregulation, which began during the Carter
administration and has since radically transformed broad swaths of
the sprawling service sector, including airlines, energy, banking,
railroads, telecommunications and, most recently, electricity. More
competition helps rein in inflation directly, and a new wealth of
alternatives keeps strikes or other disruptions from creating
bottlenecks. (Remember what life was like before faxes, cell phones
and e-mail?) "They all kind of connect the economy together,"
Frankel said.
Then there's the computer revolution. Information technology
helps companies do everything they do -- notably, managing inventory
-- more flexibly and efficiently. But innovation is also driving
down computer prices, and rapidly enough to take half a percentage
point off the overall inflation rate, according to Gordon.
More prosaic changes in the way the American labor market works
may be as important as globalization. Alan B. Krueger of Princeton
University and Lawrence F. Katz of Harvard recently published a
study suggesting that a host of small, incremental changes --
including the decline of unions, the growing role of temporary-help
firms, even welfare reform -- have made the labor market more
efficient. That may be why an unemployment rate below the
prevailing average of the 1950s and 1960s has yet to set off
bidding wars among employers.
And though the labor market may be tight, American business is
still operating with a lot of spare capacity, the product of an
investment boom spurred by lower interest rates and a rush to
embrace technology. Utilization rates remain relatively low even
after eight years of economic expansion -- one reason that companies
find it hard to raise prices. "That could explain why inflation is
lower than you'd think just looking at unemployment," Frankel
said.
That investment boom has had another powerful anti-inflation
effect. Productivity has been growing at around 2 percent a year,
double the rate that prevailed in the 1970s and 1980s. Greater
efficiency, in turn, has made it possible for employers to increase
compensation at a higher pace than the inflation rate without
adding much to their costs. "We've had an acceleration of
productivity growth, and it takes a while before people build that
expectation into wages," Krugman said.
Of course, even the most open, flexible, productive economy can
suffer inflation. Inflation, as Milton Friedman, the Nobel
Prize-winning economist, has said, is ultimately a monetary
phenomenon, and is therefore determined by policy makers in
Washington, most notably the Fed. Recall how the low-inflation
post-war era ended: tax cuts and guns-and-butter spending under
Presidents Kennedy and Johnson and an accommodating central bank
let the inflation genie out of the bottle even before the
Organization of Petroleum Exporting Countries quadrupled oil prices
in 1973.
Putting the genie back in the bottle cost the nation a couple of
nasty recessions and years of high unemployment and lost output.
Today, the memory of the high human and political costs of wringing
inflation out of the system helps keep inflation at bay, much as
memories of the Great Depression have kept deflation at bay. Three
times in 10 years, Alan Greenspan has struck pre-emptively with
interest-rate increases to ward off any acceleration before it
could even begin, in 1989, 1994 and now -- strikes that so far, at
least, seem to have served the economy well.
