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The road to zero inflation.

This article discusses whether a 4 to 5 percent inflation rate should be accepted or brought lower. Price stability cannot be achieved without some loss of employment and real output. Thus far the current Federal Reserve has expressed a belief in long-run price stability. However, the real test will be whether the Federal Reserve will refocus its policies on the long-run objective of price stability once the economy turns the corner from recession to recovery.

FOR MORE THAN A DECADE, the Federal Reserve has had as its top priority the achievement of an inflation-free economy. That goal has proved to be elusive. The inflation rate declined substantially from 1980 through 1982, when the economy went through two recessions, the second of which was the longest and deepest of the postwar period. Since then, the inflation rate has hovered between 4 and 5 percent.

Today's 4 to 5 percent inflation rate looks good compared to the double-digit figures of the late 1970s (See Chart 1). However, the current inflation rate is approximately equal to the average for the entire period since the end of World War 11, and well above the typical rate prevailing during the first twenty-five years of the postwar period.

When Paul Volcker left his post as Chairman of the Federal Reserve Board in 1987, he was a national hero because of what the Federal Reserve (Fed) had accomplished during his stewardship. At the time, there was concern that his successor, Alan Greenspan, might not be as dedicated to reducing inflation as Volcker had been. That issue is not fully settled, but the Greenspan Fed has been tougher on inflation than the Bush Administration would have liked. Indeed, officials of the Bush Administration grumbled loudly last year about the limited and gradual response of the Federal Reserve's monetary policy to the slower economic growth that developed in the first half year, and the recession that followed the Iraqi invasion of Kuwait in August.

Politicians are typically reluctant to support strong anti-inflationary policies while they are in office, especially in an election year. Perhaps the carping that was heard about timid monetary policies in 1990 can be explained on those grounds alone. I suspect, however, that the problem goes deeper - that some people, at least, are getting weary of a decade-long fight against inflation that has been less than fully successfully.

Should we accept 4 to 5 percent inflation as the best that can be done, or at least as a practical goal? Chairman Greenspan and many of his colleagues at the Federal Reserve System apparently do not think so. They have strongly supported a bill introduced by Congressman Stephen Neal (Democrat, North Carolina) to establish price stability as the long-run goal of Federal Reserve policy. As Greenspan has indicated, price stability does not mean literally zero inflation, but an inflation rate so low that it no longer enters as a significant factor in economic decision-making. In the early 1960s, for example, the inflation rate was between 1 and 2 percent, and that would very likely satisfy Greenspan's criterion.

Will the Federal Reserve persist in its efforts to bring down inflation? If so, what will be required to reach the objective of price stability? These are not easy questions to answer. History suggests, however, that the road to zero inflation may be long and bumpy.


Let me begin by knocking down what I believe is a straw man. It is sometimes argued that one barrier to the achievement of price stability is the failure of competition to work effectively in markets for services. For many of the goods that consumers buy, competition is fierce, because domestic producers face the threat of losing market share to imported goods if they do not produce and sell high-quality products at competitive prices. Over half of what we as consumers buy, however, consists of services, not goods.

During the year ended March 1991, prices of all consumer items rose 4.9 percent. Prices of commodities, which make up 45 percent of the Consumer Price Index (CPI) rose 3.8 percent, while prices of services (55 percent of the CPI) increased 5.8 percent. A particularly bad actor in the service area was medical services, whose prices increased 9.7 percent. Within the medical services component, the rise in hospital costs has been accelerating during the past five years.

There are probably few, if any, sectors of the economy in which competition works less effectively to hold down the rise of costs and prices than in hospital services. Nonetheless, competition probably also works poorly in such areas as public transportation services and educational services, whose prices are rising considerably faster than the overall rate of consumer inflation.

Inflation control would certainly be easier if competition worked better in the service industries, but that is not the main obstacle to the achievement of price stability. In the long sweep of history, the inflation rate for consumer services generally tends to move in the same direction as the rate of price change for commodities, as indicated in Chart 2. On average over the past three decades, prices of consumer services have increased about 1 1/2 to 1 3/4 percentage points faster than prices of consumer commodities.

That inflation rates for commodities and services should be rather closely linked over the long run is no accident, but a reflection of the fact that long-run changes in wage rates in servicing-producing and commodity-producing industries are similar because of competition for workers. The costs of producing services, however, rise faster than the costs of producing

commodities because of the slower advance of productivity in the servicing-producing industries.

This long-run relation between service- and commodity-price inflation means that if the rise of commodity prices were reduced to, say, I percent a year, service price inflation would ultimately come down to about 2 1/2 to 2 3/4 percent. The average for all consumer items would then be a little less than 2 percent. Presumably, that would satisfy almost everybody.


The Federal Reserve's efforts to achieve price stability would give rise to less opposition politically if price stability could be achieved with relatively little pain and sacrifice. Monetary economists have sometimes argued that bringing an end to inflation would be much less painful if the Federal Reserve were to make a firm, unyielding commitment to price stability and then pursue an unwavering course of monetary policy consistent with that objective. Business, workers, and consumers, it is argued, would then put aside the inflationary habits that underly their wage, price, and buying decisions, and the process of squeezing inflation out of the economic system would be less painful.

This is an intellectually attractive idea, but it is hard to find persuasive empirical support for its validity in U.S. economic history. For example, the new course of monetary policy launched by the Federal Reserve in October 1979 was as clear and forceful an attack on inflation as has occurred at any time in Federal Reserve history. Yet, the diminution of inflation during the early 1980s appears to be explained principally by the wide gap between potential and actual real GNP, together with much smaller contributions from relative declines in food, energy, and import prices.(1)

More recent experience has not been much more encouraging. Since Greenspan took office as Chairman of the Federal Reserve Board in August 1987, growth of the monetary aggregates has been held to a moderate pace: MI has increased at an annual rate of 3 1/4 percent, while M2 has risen at a 4 1/2 percent annual rate. During the course of Greenspan's tenure, real economic growth gradually slowed and finally turned negative late last year. Alas, there are yet no convincing signs of significant progress in reducing core inflation.

I reluctantly conclude that price stability will be accomplished only if the nation is prepared to pay the price in terms of lost employment and real output. Indeed, I know of no major country in the world that has succeeded in wringing inflation out of its economy with a minimum of pain.

Putting a price tag on regaining price stability may be impossible, but some economists have been bold enough to try. For example, the late Arthur Okun, Chairman of the Council of Economic Advisers under President Johnson, estimated in 1978 that reducing inflation in the U.S. economy by I percentage point would cost about 10 percent of a year's GNP.(2) More recent estimates have put the bill at about half that amount.(3) Even these more recent estimates, if taken seriously, imply a very high cost of reducing inflation - approximately $275 billion for each percentage point decline in the inflation rate.

Individuals who live on fixed incomes would likely be happy to see the U.S. bite the bullet on the inflation problem. On the other hand, persons who lose their jobs or their businesses because of anti-inflationary policies might well take exception. Can it possibly be worth the cost, they might ask, to rid the economy of inflation?

From the standpoint of economic welfare generally, controlling inflation can be worthwhile if economic efficiency improves modestly in an inflation-free environment. For example, if inflation-distorting effects are removed from the decision-making process, businessmen may focus more on efforts to improve productivity and less on ways to get around the effects of inflation. Then, the economy can grow faster, and over time make up for the loss of output entailed in achieving price stability. The improvement in efficiency does not have to be large if the economy's growth is permanently increased by lower inflation. For example, if the economy's long-term potential growth rate could be raised by just 0.1 percentage points by a reduction in the inflation rate, the present value (at a 4 percent real discount rate) of the additional output that could be produced during the next ten years would be a little over $250 billion at today's prices. For a twenty-year period, the present value of the additional output would be roughly $900 billion.


Chairman Greenspan laid out clearly the Federal Reserve's strategy for bringing down inflation in Congressional testimony early in 1990. "Approaching price stability," he said, "may involve a period of expansion in activity at a rate below the growth in the economy's potential, thereby relieving pressures on resources. Once some slack develops, real output growth can pick up to around its potential growth rate, even as inflation continues to trend down. Later, as price stability is approached, real output growth can move still higher, until full resource utilization is restored."(4)

The Federal Reserve was seeking to achieve its goal of zero inflation without creating a recession, which Chairman Greenspan characterized as unnecessary and destructive. The strategy, rather, was to create a small amount of slack in the economy and wait patiently for inflation to unwind. Such a strategy for reducing inflation may be no less costly than creating a recession, but it is likely to be more readily accepted politically.

Might the Federal Reserve's strategy have worked in the absence of the recession that set in during the autumn of 1990? No one knows for sure. Nevertheless, history does not provide much hope in that respect. For example, the economy was operating at a level considerably below its potential in the years from 1983 to 1986 when the unemployment rate remained above 7 percent. Yet, the inflation rate (apart from a temporary drop in energy prices in 1986) remained stuck at 4 to 5 percent. Similarly, in 1976 and 1977, the economy emerged from a deep recession but the unemployment rate remained over 7 percent on average. The inflation rate was not significantly dented.

Indeed, apart from periods of recession and the early stages of recovery, there has been only one period since the end of World War 11 in which the inflation rate declined significantly - and that was when mandatory wage-price controls were used to suppress inflation beginning in the autumn of 1971. The unhappy result of that effort was an explosion of wages and prices when the control program was dismantled in the spring of 1974.


Where will the Fed under the Chairmanship of Alan Greenspan go from here in the pursuit of its stated long-run goal of price stability? How high a price are the monetary policymakers willing to pay in terms of lost output and unemployment? Are they prepared to take a significant amount of political heat without backing down? The conduct of monetary policy since August 1987 tells us a good deal about the Federal Reserve's tradeoffs. The next year will tell us even more.

When Greenspan became Chairman of the Federal Reserve Board in August 1987, the economy was growing at a rate well in excess of its long-run potential; unemployment was declining and the dollar's value had been falling in international exchange markets during most of the year. Although signs of an upturn in wage rates, costs, and prices were not yet abundant, continuation of growth at anything like the pace of the first half of 1987 would eventually have led to worsened inflationary pressures. There was no real alternative but for the Fed under Alan Greenspan's leadership to continue the move toward restraint initiated earlier in the year when Volcker was Chairman.

For its additional moves toward restraint in 1988, a presidential election year, the Fed surely deserves an accolade or two. Tightening in the midst of a Presidential election is never easy, even when the economics of the case is clear. But the Federal Reserve did so, raising the federal funds rate from 6 1/2 percent in March to 8 3/4 percent in December, and increasing the discount rate from 6 to 6 1/2 percent in August of that year. And by the spring of 1989, growth of M2, the Federal Reserve's principal monetary aggregate target, bad declined to an annual rate of 3 percent or a little below.

Some of the luster of those anti-inflationary steps was perhaps lost, however, by persistent rumors in 1988 that Board members and Reserve Bank presidents did not see eye to eye on policy. In particular, the Reserve Bank presidents allegedly bad to push hard to get the Board to raise the discount rate from 6 percent to 6 1/2 percent in August 1988 when the federal funds rate was already up to 8 percent. Nonetheless, the Federal Reserve got the job done, and a potentially flowering inflation was nipped in the bud. We may justifiably conclude that the current Fed is prepared to accept the economic and political costs of ensuring that inflation does not accelerate from the 4 to 5 percent range prevailing in recent years.

The period from early 1989 through the third quarters of 1990 yields some clues as to how much further the Fed is willing to go to achieve its stated objective of price stability. During this period, the Fed indicated by its actions, as well as Chairman Greenspan's words cited above, that it was not prepared deliberately to provoke a recession to curb inflation. In marked contrast to policies pursued during previous economic expansions, the Fed began to lower short-term interest rates far in advance of an economic downturn. Between March 1989 and August 1990, the federal funds rate declined 175 basis points. During previous postwar expansions following the Treasury - Federal Reserve Accord of 1951, monetary policy had continued to tighten right up to, and sometimes a little past, the downturn in overall business activity.(5) Apart from the recessions of 1980 and 1981-82, it might be argued that Fed policy makers were not deliberately creating a recession to break the back of inflation; rather, they were simply not foresighted enough to see the recession coming. Whatever the motivation behind those earlier episodes of monetary restraint, it seems fair to conclude that the Fed in 1989-90 was less willing to risk a recession to curb inflation than it had been in the postwar periods prior to 1979. Or perhaps it genuinely believed that it was unnecessary to do so.

The period from the autumn of 1990 to the present really doesn't tell us much about the Fed's tradeoffs between output and inflation. To be sure, monetary policy eased to cushion recessionary forces, as it has repeatedly done throughout the postwar period. Thus far, the relative decline in shbort-term interest rates has been moderate compared with postwar recessions, but so also has been the overall retrenchment in economic activity. I find it hard to fault the Fed for easing fairly aggressively once the recession got underway, even though that required temporary suspension of a longer-run objective of reducing inflation. The dangers of the economic downturn beginning to cumulate were simply too great - as they always are in a recession.


Developments on the price side during recent years are a bit disconcerting to those who want to see price stability restored in the near future. Nonetheless, perhaps all hope is not lost. It may be argued that insufficient time has elapsed to evaluate the Fed's anti-inflation strategy pursued prior to August 1990; or it may be that the response of wage rates, costs, and prices to increased slack in labor and product markets since last autumn still lies ahead of us. Thus, we might see a repeat of the 1969-70 recession experience, when inflation showed no sign of abatement until the recession was over and then began to decline significantly during the early months of the recovery. Consumer price figures for that period are quite striking in fact. Over the four quarters of 1970, while the recession was in progress, consumer prices excluding food and energy increased 6 1/2 percent - compared with 5 3/4 percent in the last four quarters of the prior expansion. During the first three quarters of recovery in 1971 (before wage-price controls were imposed), the inflation rate so measured had dropped to under 4 percent.

If the recovery from this recession proceeds along the lines expected by the consensus forecast, the outlook would be propitious for declining inflation during the early quarters of recovery. The consensus forecast is for real GNP growth over the next four to six quarters not far above the economy's long-term growth potential - which I would estimate to be in a range of 2 1/4 to 2 1/2 percent. For example, the April 10, 1991, Blue Chip Economic Indicator consensus forecast is for real GNP growth at an annual rate of 2.7 percent from mid-1991 until mid-1992. If that forecast is reasonably accurate, a modest tightening of monetary policy some time during the first year of the recovery would probably suffice to keep the gap between actual and potential output near its cyclical peak, creating conditions favorable for a moderation of wage and price increases.

I hope the Fed is prepared to refocus its policies on the long-run objective of price stability once the economy turns the corner from recession to recovery. The Fed will need to remember that solid progress against inflation has been notably lacking during the past five or six years. In this respect, I find recent press stories of dissension within the Fed this spring a bit troubling, because I suspect they stem as much from policy disagreement as from procedural issues.

Indeed, if the next year does not bring clearly measurable progress toward reducing inflation below the prevailing 4 to 5 percent range, my expectations regarding the prospects for attaining price stability are best captured by the following story.

A pedestrian walking down Constitution Avenue in the nation's capital paused between 20th and 21st streets to admire the beautiful Federal Reserve building. He noticed a gentlemen sitting on the steps with a trumpet in his lap, and asked, "What are you doing there?" "I have been hired by the Federal Reserve Board," the gentlemen replied, "to trumpet and herald the arrival of price stability when it occurs." "How much are they paying you for this," asked the passerby? "Two hundred dollars a month," responded the trumpeter. "Why that is a miserably low wage," exclaimed the passerby. "True enough said the trumpeter, "but remember, this is a lifetime job."


1 See Robert J. Gordon, Understanding Inflation in the 1980s," Brookings' Papers on Economic Activity, 1:1988, pp. 263-99.

2 Arthur M. Okun, "Effective Disinflationary Policies," American Economic Review, Vol. 68, (May 1978, Papers and Proceedings, 1977), pp. :348-52.

3 Gordon, op. cit., p. 290.

4 Alan Greenspan, Testimony before the Subcommittee on Domestic Monetary Policy, House Committee on Banking, Finance and Urban Affairs.

5 A notable exception to this statement occurred in the first half of 1967, when the Fed eased its policies in response to a brief slowdown in economic growth.
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Title Annotation:A Review of Federal Reserve Policy
Author:Gramley, Lyle E.
Publication:Business Economics
Date:Jul 1, 1991
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