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The road to zero inflation.

The Road to Zero Inflation

For more than a decade, the Federal Reserve has had as its top priority the achievement of an inflation-free economy. That goal has proven 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. A little further progress was made in early 1983, but was reversed later that year. 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 II, and well above the average rate that prevailed during the first 25 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 concern has since been laid to rest. In both words and deeds, Greenspan has taken a tough line on inflation. So much so, in fact, that officials of the Bush administration have been grumbling loudly this year about his unwillingness to ease the Federal Reserve's monetary policy in response to slower economic growth.

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

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 obviously do not think so. They have strongly supported a bill introduced by Congressman Stephen Neal (NCD) 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, into 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.

What would it take to reach that objective? It is nor an easy question to answer. History teaches, however, that the road to zero inflation is likely to be long and bumpy.

Inflation in services

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. More than half of what we as consumers buy, however, consists of services, not goods.

During the year ended in May 1990, prices of all consumer items rose 4.4 percent. Prices of commodities, which make up 45 percent of the Consumer Price Index (CPI) rose 3.3 percent, while prices of services (55 percent of the CPI) increased 5.2 percent. A particularly bad actor in the service area was medical services, whose prices increased 9.3 percent. Within the medical services component, hospital costs rose 11 percent (See Chart 2).

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 3. On average during the past three decades, prices of consumer services have increased 1.7 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. Rather, the relationship between those rates is 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 service-producing industries.

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

Costs and benefits of reducing inflation

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. Businesses, workers and consumers, it is argued, would then put aside the inflationary habits that underly their wage, price and buying decisions, and inflation would melt away rather quickly. This is an intellectually attractive idea, but it requires that ways be found to implement it. Unfortunately, no major nation in the world has succeeded in wringing inflation out of its economy without a painful loss of jobs and output.

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 Advisors under President Johnson, estimated in 1978 that reducing inflation in the U.S. economy by 1 percentage point would cost about 10 percent of a year's GNP. More recent estimates have put the bill at about half that amount. 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, or between $675 and $700 billion to reduce inflation from 4 1/2 percent to 2 percent.

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, the Mortgage Bankers Association of America's economics department estimates the economy's long-term potential growth rate at 2.5 percent. If the potential growth rate were raised to just 2.6 percent 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 10 years would be a little more than $250 billion at today's prices. For a 20-year period, the present value of the additional output would be roughly $900 billion.

The Fed's anti-inflation strategy

Chairman Greenspan laid out clearly the Federal Reserve's strategy for bringing down inflation in congressional testimony earlier this year.

"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."

The Federal Reserve is seeking to achieve its goal of zero inflation without out creating a recession, which Chairman Greenspan has characterized as unnecessary and destructive. The strategy, then, is 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.

Will such a strategy really work? No one knows for sure, because it has never been tried before. Nevertheless, history does not offer a lot of encouragement. For example, the economy was operating at a level considerably below its potential in the years from 1984 to 1986 (See Chart 4), when the unemployment rate averaged 7 1/4 percent, compared with the 5 1/2 percent prevailing currently. 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 in excess of 7 percent on average. Alas, inflation was not significantly dented.

Indeed, apart from period of recession and the early stages of recovery, there has been only one period since the end of World War II 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. It is not an experiment that our country should try again.

There is, thus, no guarantee that the Fed's current anti-inflationary strategy will ultimately be successful. A recession may be required to bring down inflation. We can be entirely sure, however, that to have a realistic chance of success with its present strategy, the Fed will have to stick to its guns much longer. The economy may need to continue growing at less than 2 1/2 percent a year for several more years before significant progress is made toward price stability.

I strongly believe that the Federal Reserve is prepared to stay the course. Central bankers get paid to take a long-run point of view regarding economic performance. That is why reducing inflation appears to them worthwhile, even though the short-run costs of achieving price stability are high. Lyle E. Gramley is the senior vice president and chief economist for the Mortgage Bankers Association of America, Washington, D.C. From 1980 to 1985, Mr. Gramley was a governor of the Federal Reserve Board.
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Title Annotation:policies of the Federal Reserve's Alan Greenspan
Author:Gramley, Lyle E.
Publication:Mortgage Banking
Article Type:Cover Story
Date:Sep 1, 1990
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