August 22, 1999


Inflation Just Doesn't Add Up

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  • Issue in Depth: Federal Reserve

    Barely 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.

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