James A. Wilcox

English

Research Papers in Economics

FRBSF WEEKLY LETTER
December 14, 1984
Inflation: Retreating or,Reheating?
Actual inflation continues ata relatively low rate
compared to its double-digit pace ofafew years
ago. Both the consumer price index and the price
index for total output-theGNPdeflator, have
measured inflation in the neighborhood offour
percentoverthe lasttwoyears. Given thatoverthe
same period the unemployment rate fell more
than three percentage points and real output grew
morethan ten percent, the failure ofinflation to
rise is particularly noteworthy. In fact, manyfore-
casters have been surprised by its continuing low
rate and have accordingly revised their inflation
forecasts downwardforthis year and next.
One signal thatoverall inflation may remain low
for the next few quarters is given by prices at the
wholesale level. Producer price changes often
foretell consumer price changes since cost in-
creases at the wholesale level tend to getpassed
onto the retail level. The inflation rate in producer
prices has been even lowerthan that in retail
prices. And recently ithas fallen even further.
Producer prices have only risen three percent in
the two years since the current recovery began, in
contrast to theirten percenttotal rise in the first
two years ofthe 1975-1980 recovery. From July to
October, producerpricesactuallyfell. Fewexpect
deflation at the retaiI level, butthe low rates of
increase in producer prices have played asignifi-
cant role in expectations ofcontinued low infla-
tion for the nextfewquarters.
Thecurrent relatively lowrates ofinflation aredue
in part to transitory factors. These factors have de-
pressed the observed, or actual, rate ofinflation
below its underlying, longerterm component
which is determined primarily by fundamentals
such as thebasicdirectionofmonetary policyand
the trend in laborproductivity. This Letter discus-
ses these temporary factors andthe contributions
they havemadeto reducingboth theobserved and
the underlying rates ofinflation and to keeping
current inflation low.
Importanceof imports
Because expendituresfor imported goods and ser-
vices currently exceed $450 billion peryear-
aboutone-eighth ofGNP-changes in import
pricesdirectlyaffecttheoverall domestic inflation
rate. They also exert indirect pressures thatare
perhaps moreimportant. Chart 1showstherecent
inflation rates oftheConsumer Price Index and of
a price indexfor imports. In 1979 and 1980, the
prices ofimported goods rose much more rapidly
than otherprices. ThedoublingofOPEC oilprices
was responsible for virtually all ofthis increase in
the relative priceof imports. Since then, import
prices have risen very much less than otherprices,
and forthe last three years, haveactually fallen.
The fall in import prices relative to the prices of
domestically produced goods'and services has
been duetothe recentstrength ofthe U.S. dollarin
relation to other major currencies. The trade-
weighted real value ofthe dollar has risen about
40 percent since 1980. As a result, foreign suppli-
ers have been able to charge lowerdollarprices
while maintaining the profitabilityoftheir exports
tothe United States. The lowerdollarprices of
imported goods show up in the price indexes for
goods purchased by Americans, and thereby hold
downtheoverall rate ofincreaseofthose indexes.
Indirectly, the lowerAmerican priceof imports
has led competingdomestic producers to hold
downtheir prices. Almost everythingwe import
has aclosecounterpart, orsubstitute, produced in
the U.S. Autos, steel, petroleum, and clothing are
large domestic industries that mustcompete with
foreign producersofthesame goods. Roughly half
oftotal domestic production consists ofgoods
with substitutesthatareorcould be imported.This
competition from foreign goods, whose dollar
prices have remained relatively low because of
the strong dollar, has kept a lidon both domestic
producers' and workers' ability to raise prices.
The price ofone major imported commodity,
petroleum, is not directly affected by changes in
the value ofthe dollarbecause its price is set
primarily in dollars. But even the price ofpetro-
leum has fallen. Since the early 1980s, the dollar
priceofabarrel ofOPEC crude has fallen byabout
one-third because the worldwide demand foroiI
has softened markedly compared to demand in
the late 1970s. Among the reasons forweaker oil
demand are the continuing increases inenergy
efficiencyand the very lowreal growth ratesoftheFRBSF
world economy. The strong dollaralso has helped
reduce the priceofoil by makingthe costofoil
higherforcountriesotherthan the UnitedStates. It
thereby saps those countries' demand for oil and
puts downward pressure on oil prices.
The 14-percent increase in the real value ofthe
dollarovenhepasttwoquartersgivesusevery .
reason toexpect inflation to remain quiescent
overthe nextyear and perhaps to fall further.
However, shouId the real valueofthe dollarfall
significantly, short-term directand indirectup-
ward pressures on inflation, perfectlyanalogousto
those weexperienced throughout much ofthe
decade ofthe 1970s, will re-emerge.
Onceagain, inflation and unemployment
Since labor costs constitute approximatelythree
fourths ofcosts forthe economy as a whole,
changes in the growth rate of labor costs also play
a significantrole in determiningshort-run changes
in the inflation rate ofdomestically produced
goods and services. Howfast wages rise depends
on the amountofslack in the labor market. The
unemployment rate is a good signal ofthis slack
and, to a large degree, ofthe general level of
demand for domestically produced output. Its
level, then, is likelyto be an importantfactor in
determining howfast wages rise.
Chart 2 plots the course overthe last halfdozen
years ofthe level ofthe unemployment rate and
the change in the growth rate of laborcompensa-
tion per hour. Duringthe late 1970s, the unem-
ployment rate fell to relatively low levels and the
growth rate ofcompensation per hour rose. With
the higher unemployment rates ofrecent years,
labor costs have grown slower and slower. This
year, forexample, compensation perhour is grow-
ing about halfas fast as itgrewduring 1980. As
long as the amountofslack in labor markets re-
mains substantial, such slowing is to be expected.
When the economy returns to more normal levels
ofunemployment, this downward pressure on
wage and price inflation will disappear.
Deregulation and disinflation
The lastfewyears have also seen somechanges in
government budget and regulatory policies that
have helped reduce inflation in the short-run.
Compensation costs, forexample, will notbe
pushed up nearly as much by payroll tax hikes
between 1982 and 1985 as theywere in the period
1978 through 1981, when payroll taxes increased
substantially. These increased costs apparently
were passed on by employers as price increases
thattemporariIyraisedtheinflation rate. Oncethis
pass-through was completed, the upward pres-
sure on short-term inflation would have evapo-
rated even withoutthe helpofother anti-inflation
governmentpolicies.
A similartemporary reduction in short-term pres-
sure on inflation emanated from (de-)regulation
policy. The removal ofa wide range ofprice regu-
lations in the communications and transportation
industries prompted price declines in those sec-
tors. These pricedeclines fed back intodownward
pressure on employee wages. Together, lower
costs and prices in deregulated industries helped
reduce the overall inflation rate temporarily. But,
again, oncethe adjustment is completed, the
underlying inflation rate will re-establish itself.
Summing up
The economy's underlying rate of inflation has
been reduced substantially in the past fouryears.
Overthattime,theactual rate ofinflation has been
even lowerthan the underlying rate. The strength-
ening ofthe dollar, slack aggregate demand, and
adjustmentto less price regulation have each
played arole in bringingdown both theactual and
the underlying rate of inflation. However, the
actual rate will remain belowthe underlying rate
onIytotheextentthatfactors likethese continueto
exertdownward pressure. Oncethe dollar stabil-
izes and the adjustmentto its level is complete,
and once the economy finishes its adjustment to
more normal levels ofur'lemployment and capa-
city utilization and to deregulation, actual infla-
tion will move toward its underlying rate. As yet,
there are indications that these adjustments are
notcomplete. Until they are complete, the under-
lying rate itself may recede further. These forces
together may keep inflation relatively lowforthe
near future.
James A. WilcoxChart 1
Import Prices
Influence Domestic Inflation
(4·Quarter Growth Rates)
Percent
30
20
10
01----------\------_,..;;.-----
.10 '--_-'-_--'-__ '--_--'--_---L._~'_______J
1978 1979 1980 1981 1982 1983 1984
Chart 2
Higher Unemployment and
Slowing Growth in Labor Costs
0.5
o
-0.5
-1
Percent
(4·Quarters)
\
Change in
Compensation Growth ~
",
I '\
I \
I \
I \
I \
\
I \ , \
9
7
8
,.. . , ....__...
, ... ,
Unemployment!
Rate ,
6 ......."',J .,
Percent
10
11
5 ~~
1978 1979 1980 1981 1982 1983 1984
Opinionsexpressed in this newsletterdo not necessarily reflect theviews of the managementof the Federal Reserve Bank ofSan
Francisco, orofthe Board ofGovernorsofthe Federal Reserve System.
Editorial commentsmaybe addressed totheeditor(GregoryTong) ortotheauthor....Freecopiesof Federal Reserve publications
can beobtainedfrom the Public Information Department, Federal Reserve Bank ofSan Francisco, P.O. Box 7702,San Francisco
94120. Phone(415) 974-2246.uo~6U!4S0m 4o~n U060JO OpOA0U
040PI !!omoH O!UJOdUO) ouozPl:J o~soll:J
O)SPUOJ~ UOS
JO ~uo8
aAJaSa~ IOJapa~
~uew~Jodea lpJoese8
BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
11/28/84
Change
from
11/21/84
Change from 12/28/83
Dollar Percent?
Loans, Leases and Investmentsl 2 186,775 - 376 10,750 6.6
Loans and Leases1 6 168,039 - 319 12,684 8.8
Commercial and Industrial 51,621 157 5,658 13.3
Real estate 61,371 38 2,472 4.5
Loans to Individuals 31,030 180 4,379 17.8
Leases 5,075 1 12 0.2
U. S. Treasury and Agency Securities2 11,631 - 58 - 876 - 7.5
OtherSecurities2 7,105 0 - 1,058 - 14.0
Total Deposits 189,069 -2,103 - 1,928 - 1.0
Demand Deposits 42,805 -1,842 - 6,432 - 14.1
Demand Deposits Adjusted3 28,892 219 - 2,439 - 8.4
OtherTransaction Balances4 12,200 - 198 - 575 - 4.8
Total Non-Transaction Balances6 134,064 - 63 5,079 4.2
MoneyMarketDeposit
Accounts-Total 40,007 344 410 1.1
Time Deposits in Amounts of
$100,000 ormore 40,427 - 261 2,262 6.4
Other Liabilities for Borrowed MoneyS 21,902 -2,290 - 1,105 - 5.2
Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency(-)
Borrowings
Netfree reserves (+)/Netborrowed(-)
Penodended
11/19/84
18
21
2
Penodended
11/05/84
55
133
78
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes U.S. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephonetransfers
S Includes borrowingvia FRB, TI&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately
7 Annualized percentchange

Inflation: retreating or reheating?

http://www.frbsf.org/publications/economics/letter/1984/el84-50.pdf

Inflation: retreating or reheating?

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics