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Attaining price stability.

Could it be that the Fed believes that price stability has finally been achieved? If Chairman Greenspan's recent remarks to a group of Tokyo bankers are a reliable indicator, the Fed believes inflation has been licked for the near term and easy credit policy can commence to fuel the reviving economy in 1993.

When Federal Reserve Chairman Alan Greespan speaks, financial markets listen. His every word is dissected for possible nuances that may have escaped a casual observer. Suprisingly, one of the most intriguing of Greenspan's recent remarks has gone largely unheralded.

Speaking before a group of Tokyo bankers in mid-October 1992, Greenspan stated that "the true underlying rate of inflation in today's world may not be far from what I would call price stability."

For more than a decade, the Federal Reserve (Fed) has had as its top priority the achievement of an inflation-free economy. To reach that goal, the U.S. economy was put through the wringer of deep recession in the early 1980s, and the monetary screws were tightened again beginning in 1987, contributing to the slowdown in growth that began two years later.

While those efforts have succeeded in reducing inflation, they have not stopped the rise in prices altogether. Nonetheless, the Fed has made it clear that the achievement of price stability does not mean having literally zero inflation. "Price stability," to quote Greenspan, "is a condition in which households and businesses do not base their decisions on expectations of continued price inflation."

The importance of the Tokyo statement

Central bankers tend to be very cautious people, particularly when it comes to claiming victory over inflation. They know that, in the long run, inflation is a monetary phenomenon and that it could recur if they do not remain vigilant. Given that fact, Greenspan's Tokyo statement strikes me as profoundly significant. He is telling us, I believe, that price stability has now been achieved, for all practical purposes, so that the Federal Reserve's priorities can begin to shift away from a primary focus on bringing down inflation and toward encouraging a stronger pace of economic expansion.

If Greenspan's statement reflects a correct assessment of developments on the inflation front, it is extremely good news for the mortgage banking industry. An inflation-free economy means low interest rates, and that is quite obviously good for housing and mortgage banking. Moreover, a greater willingness by the Fed to accommodate economic growth would help foster the improvement in employment, consumer incomes and confidence needed to support a solid upswing in individuals' purchases of homes and other big-ticket items.

The evidence

A careful look at the evidence provides support for Greenspan's optimism. During 1993, inflation is more likely to go down in the United States than to go up. With price developments abroad also favorable, the basis is being laid for a prolonged period of tranquility on the wage and price front.

The great battle against inflation in the United States began in 1979, when prices were rising by more than 10 percent a year. Success in reducing inflation was not immediate, but during the deep recession of 1981-1982, the rate of price advance dropped very sharply. By the summer of 1982, however, the recession had become so severe that the Fed had no choice but to abandon temporarily its anti-inflationary stance to avert a collapse of the economy. And when economic growth turned up again, prices commenced rising at roughly 4 percent to 5 percent a year, and the inflation rate remained in that general range until recently.

Since the end of 1990, the inflation rate has dropped significantly further, to around 3 percent. As Figure 1 indicates, there were two earlier periods in the 1980s when inflation was temporarily lower than it is currently - at the depth of the 1982 recession - when price discounting was extremely heavy - and in 1986, when oil prices collapsed. The 1986 respite from inflation ended when oil prices turned up again; it was too narrowly based to endure. The 1982 quiescence of inflation ended because it was not accompanied by comparable reductions in the rise of costs. Prices had to begin rising faster again to cover increasing costs.

The current lower inflation rate, on the other hand, is broadly based - it is apparent in virtually every category of consumer goods and services - and even more importantly, it is solidly buttressed by substantial reductions in the rise of costs.

The wage slowdown

Rates of increase in total compensation per worker in the private sector rose substantially in the latter years of the 1980s. The increase reflected a gradual rise in wages and salaries and an explosion of benefit payments - particularly health-care costs. By the third quarter of 1992, the rise of compensation had slowed to 3 1/2 percent; both wages and salaries and benefits are rising less rapidly now than two years ago.

This improvement stems in part from weaker demands for labor, relative to the available supply of workers. An important dimension of the wage slowdown, however, comes from strenuous efforts by American businesses to restructure, cut costs and improve profit margins.

Whether efforts to restructure have enduring effects on costs depends critically on whether or not long-term improvements occur in efficiency, and hence in productivity. It is too early to arrive at a definitive judgment, but here, too, the available evidence is very encouraging. The trend growth rate of productivity - measured from the third quarter of 1981 to the second quarter of 1990, the peaks of the past two business cycles - was a little above 1 percent a year.

Actual productivity fell below trend in the recessions of 1980 and 1981 to 1982, and went above trend during the years of strong economic expansion from 1983 through 1988. When the economy's growth began to slow in 1989, productivity declined, but has risen handsomely during the past six or seven quarters.

These recent increases in productivity are quite remarkable because they have occurred in the context of a weakly growing economy. It is too early to tell whether or not the trend rate of productivity is now above the 1.1 percent pace prevailing in the past decade. Even if not, restoration of actual productivity to trend levels means that the slowdown in the rise of wage costs is carrying through to unit labor costs. Actual unit labor costs are now rising less rapidly than prices, and if that continues in 1993, inflation will moderate still further.

Industrialized superpowers

share inflation progress

Progress against inflation since the late 1970s occurred not only in the United States, but also in most other major industrial countries see Figure 4). In Canada, inflation is down from 9 percent between 1976 and 1980 to 2 percent in 1992; in France, from 11 percent to 3 percent; in Italy, from 17 percent to 6 percent, and in the United Kingdom, from 14 percent to 5 1/2 percent. Japan has maintained an enviable record against inflation for more than a decade. Germany had done so also until unification of East and West Germany led to sharply higher budget expenditures and a ratcheting up of wages and prices. But the Bundesbank's tough anti-inflationary stance has began to bear fruit, albeit at the expense of a stalled economic expansion.

Indeed, throughout the industrial world, as 1992 closed, economic activity was in a severe slump and will likely remain that way in 1993. Excess industrial capacity in the United States and abroad is putting downward pressure on costs and prices everywhere, so that anti-inflationary developments in one country are reinforcing those trends in others.

The impact of trade

Restraint on inflation in the United States is also coming from dramatic increases in the availability of high-quality products at low prices produced in the developing countries of Asia and Latin America. The dollar value of our imports from the Asian NICS (newly industrialized countries) in 1992 will be 60 percent to 70 percent higher than in 1985; from Mexico, the increase over that period will amount to around 90 percent. From China, our imports in 1985 were a paltry $4 billion; in recent months, they have been running at an annual rate of more than $30 billion. American producers of tradeable goods are facing intense competitive pressures from producers around the globe; they have no choice but to hold down costs and prices.

I am confident that economic conditions both here and abroad will be conducive to continued low inflation in the United States in the next year or two. My expectation is that consumer prices will rise only about 2 1/2 percent over the four quarters of 1993. Apart from 1986, when oil prices collapsed, this would be the lowest inflation rate since 1965.

In evaluating whether a 2 1/2 percent inflation rate conforms to Chairman Greenspan's definition of price stability, three things should be kept in mind. First, based on historical relationships, a 2 1/2 percent overall rise of consumer prices next year would mean service prices rising about 3 1/2 percent, while commodity prices would rise only about 1 3/4 percent. Second, measures of price inflation are known to be biased upward, so that the true rate of commodity price rise would be less than 1 3/4 percent. That is because buying patterns continually shift toward those items rising least in price. Finally, a small rise in the price of any commodity, or group of commodities, may partly reflect quality improvements that are difficult to take into account fully in price measurements.

Are we really there?

A practical way of deciding whether or not we are now dose to the coveted goal of price stability - as Chairman Greenspan defines it - is to ask some simple questions. How many businesses do you know that are buying land and equipment today because they think the price will be higher next year? How many individuals are buying houses, autos, household appliances or furniture today because they worry that these things will cost more tomorrow?

The days when buying decisions are influenced importantly by price expectations are behind us. Chairman Greenspan is aware of this, as are other Federal Reserve officials. That is why they will be comfortable shifting their priorities from reducing inflation to achieving a more satisfactory growth rate during 1993.

The road to price stability has been a long and bumpy one, and the costs of achieving that goal have been extremely high. But the United States is now in a position to enjoy the benefits of an economic recovery not flawed by inflation.

Lyle E. Gramley is consulting economist with the Mortgage Bankers Association of America in Washington, D.C.
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Author:Gramley, Lyle E.
Publication:Mortgage Banking
Date:Jan 1, 1993
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