Thomas M. Supel

English

Research Papers in Economics

Federal Reserve Bank of Minneapolis 
Quarterly Review 
Winter 1978 
The U.S. Economy in 1977 and 1978 (p. i) 
Inflation: An Extreme View (p. 7) 
The Regional Economy in 1977 and 1978 (p. 15) 
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illllMimiSffffi Federal Reserve Bank of Minneapolis 
Quarterly Review Vol. 2, No. 1 
This publication primarily presents economic research aimed at 
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The views expressed herein are those of the authors 
and not necessarily those of the Federal Reserve 
Bank of Minneapolis or the Federal Reserve System. The U.S. Economy in 1977 and 1978 
Thomas M. Supel 
Senior Economist 
Research Department 
Federal Reserve Bank of Minneapolis 
The longest and deepest economic recession since 
the end of World War II began in the late fall of 1973 
and hit bottom in midwinter 1975. Since then the 
economy has grown vigorously: by the end of last 
year, production had increased at least 16 percent, 
and more than 7.7 million workers had found new 
jobs. 
The relative strength of the current recovery is 
evident; we need only look at the figures for real 
gross national product (GNP) to see that we have 
been doing somewhat better than in most of the 
other five postwar recoveries. But the character of 
this recovery is perplexing; for while production and 
civilian employment have been high, so, too, have 
inflation and unemployment. For this, there are no 
postwar precedents. 
The unusual concurrence of high inflation and 
unemployment should continue with the recovery in 
1978, but how high they will be and how strong the 
recovery will be is somewhat uncertain. Based on 
activity in 1977 and assumptions about economic 
policy in 1978, the recovery's pace and unusual 
character are not likely to change much in the next 
four quarters. Real GNP should grow from 4.5 to 5 
percent while the inflation rate stays in the 6 to 6.5 
percent range and the unemployment rate hovers 
just above 6 percent. This forecast may be too opti-
mistic, however, in view of early 1978 events. Severe 
weather and the coal strike appear to have notice-
ably disrupted the economy this winter, reducing, 
for example, production, retail sales, and home-
building. If these are not temporary effects, the re-
covery would likely still continue this year, but at a 
significantly slower pace and possibly with even 
higher inflation and unemployment. 
Putting the Recovery in Perspective 
According to the National Bureau of Economic 
Research, the current business cycle reached its 
recessionary low point in the first quarter of 1975. 
By the end of 1977, then, the recovery phase had 
been under way for eleven quarters, nearly three 
years. So far, how does it compare with other 
recoveries in the postwar era? 
The first chart shows real GNP—the value of 
goods and services produced in the economy, ad-
justed for price changes—during the six recovery 
periods. For ease of comparison, the five earlier 
recoveries are averaged, and all the recoveries are 
indexed to show the rate of growth from their trough 
Chart 1 
Real Gross National Product 
0123456789 10 11 
Quarters From Trough 
Current 
Recovery 
Average 
of 5 Past 
Recoveries 
1 levels. After eleven quarters, the current recovery's 
index was 116.4, which means real GNP was 16.4 
percent higher than in the first quarter of 1975. On 
average in the past five recoveries real GNP was 
15.1 percent higher than in the trough quarter. At 
average annual rates, real GNP increased 5.7 
percent in the latest recovery and 5.2 percent in the 
earlier recoveries. Obviously, this recovery is slight-
ly ahead. 
How did it get there? 
Consumers have been the main prop of GNP 
(Chart 2). By the end of 1977, real consumer 
Chart 2 
Real Personal Consumption 
Quarters From Trough 
spending in general had grown about 7 percentage 
points more than in the earlier recoveries, and 
spending for residential construction in particular 
was a phenomenal 47 percentage points higher 
(Chart 3). Much of the impetus for residential con-
struction came from the highly unusual decline of 
interest rates during this expansion. 
Government spending contributed little to the 
growth of GNP. Real federal government purchases 
of goods and services grew more than average, when 
the recovery which included the Korean War is ig-
nored (Chart 4), but state and local government 
spending did not grow nearly as much as in the previ-
ous recoveries (Chart 5). Many state and local gov-
ernments—New York City is the prime example— 
have had strapping financial problems in the last 
few years which have forced them to cut back. 
Growth in real capital outlays by the business 
sector has been even more sluggish—by the end of 
1977 it was 33 percent below average (Chart 6). Ex-
planations for this are both numerous and varied. 
The rate of capacity utilization may have been so low 
that business investment has not really been neces-
sary. Or, the foundering stock market may have 
made it more profitable to buy existing rather than 
new plant and equipment. Or, equally possible, un-
certainty about the federal energy and tax programs 
Chart 3 
Real Residential Construction 
Quarters From Trough 
Chart 4 
Real Federal Government Purchases 
\r  •j 
^ J 
V. / 
i i i  i i i  t it . J : 
1961 I 
19751 
23456789 10 
Quarters From Trough 
2  Federal Reserve Bank of Minneapolis Quarterly Review/Winter 1978 may have discouraged business spending. 
As might be expected during a period of expan-
sion, more and more jobs have been created, but 
labor market conditions have been unusual in this 
recovery. A larger share of the population was em-
ployed at the end of 1977 than ever before (Chart 7). 
However, the extremely fast growth of the labor 
force (Chart 8) kept the unemployment rate from 
dropping (Chart 9). If the labor force had grown near 
an average rate, by the fourth quarter of 1977 the 
unemployment rate would have been 2.5 rather than 
6.6 percent. Unfortunately this is merely an arith-
metic exercise and does not explain why a growing 
economy has not been able to use more of its labor 
force. 
Also unusual in this recovery: Coupled with the 
high unemployment rate has been a very high rate 
of inflation (Chart 10). 
•Trough quarter = 100; the current recovery is from the first quarter of 1975. 
Source: U.S. Department of Commerce 
Quarters From Trough 
Chart 8 
Civilian Labor Force 
Chart 9 
Unemployment Rate 
Unemployment as a Percent of the Labor Force 
Chart 10 
Price Level 
Index* 
Chart 5 
Real State & Local 
Government Purchases 
Chart 6 
Real Business Fixed Investment 
Chart 7 
Employment Rate 
Total Civilian Employment as a Percent of 
Total Civilian Population Age 16 and Over 
%  59 
Average 
of 5 Past 
Recoveries What's to come in 1978? .. • 
To make predictions for this year, we need to make 
some assumptions about government policies. Let's 
assume that the narrowly defined money supply will 
be expanded from 4 to 6.5 percent as targeted by 
the Federal Reserve last fall. Let's also assume that 
federal government expenditures for fiscal 1978 will 
be about $462 billion, as announced in President 
Carter's January budget message. During the past 
year or so, the federal government has spent less 
than its budget, but we will assume it will spend the 
full amount in 1978. Let's assume that Congress will 
pass a moderate tax cut, about the size of the Ad-
ministration's $25 billion proposal, which won't take 
effect until October. Finally, let's assume that 
before spring Congress will also pass an energy bill 
which, because of its offsetting tax changes, won't 
affect overall income in 1978, though it may cause 
some relative price adjustments. 
In addition to these assumptions about govern-
ment policies, we will assume that the OPEC nations 
will not hike oil prices, that the value of the dollar 
will not plummet enough to force the monetary au-
thorities to adopt new policies, and that economic 
growth in foreign countries will not quite match the 
United States'. It's too early to tell what the coal 
strike will do to the economy, but we will assume 
that there will be no other major strikes; during 1978 
only about 2.4 million workers' contracts are ter-
minating. 
... The recovery will continue 
Under these assumptions, and based on a closer 
look at activity last year, we think the recovery will 
continue in 1978 about as strong as it has been. 
In the final quarter of 1977, real GNP grew at an 
annual rate of only 4.2 percent, but real final sales 
(total production less inventory changes) grew 6.8 
percent. The ratio of inventories to final sales thus 
dropped far enough that in 1978 inventory growth 
should at least match sales growth. 
Business investment should contribute to eco-
nomic growth in 1978. Although sluggish over most 
of the eleven recovery quarters, it picked up in 1977 
and grew at an annual rate of nearly 15 percent. We 
expect this to moderate only slightly in 1978 since 
year-end appropriations for new plant and equip-
ment and new orders for nondefense capital goods 
were strong. 
Revenues of state and local governments also 
rebounded in 1977, so their purchases of goods and 
services should help increase aggregate demand 
this year. With some financial constraints lifted, 
these governments had built up a combined budget 
surplus of about $30 billion at the end of last year. 
Their spending in 1978, therefore, could grow as 
much as 13 percent. 
Most of housing's exceptional strength at the 
end of the year should carry into 1978 too. December 
marked the sixth consecutive month in which an 
annual rate of more than 2 million units were started. 
The very high number of unsold new homes could 
hold starts somewhat below that this year, but they 
will undoubtedly still be strong. And despite higher 
new home prices, personal income growth is likely 
to keep sales of new homes fairly brisk. 
Personal income growth, in fact, will probably 
support consumers' overall spending, though not 
quite at such high rates. During 1977, consumer 
spending grew unusually fast, and people were 
saving an unusually small part of their income. Even 
if the savings rate returns to more normal levels in 
1978, though, spending should remain fairly strong 
because consumers will probably be earning more. 
In short, the economy's momentum at the end of 
1977 should carry through 1978, with real GNP 
growing in the range of 4.5 to 5 percent. Despite the 
continuing recovery, though, unemployment and in-
flation are both likely to remain unusually high. 
Starting from the 6.4 percent rate in December 
1977, the unemployment rate may drift closer to 6 
percent by year-end. It could even settle below 6 
percent, if labor force growth slows significantly, 
but that is not likely. 
The inflation rate will almost certainly be higher 
than last year's 5.6 percent—probably in the 6 to 6.5 
percent range—and it could easily be higher. Labor 
contracts, which last year averaged 9 percent in-
creases for the total compensation package, will be 
boosting unit labor costs. Higher minimum wages, 
increased social security taxes, and other govern-
ment policies seem to preclude any reduction of 
inflation. 
Major Uncertainties 
Economists, much like weather forecasters, never 
promise 100 percent accuracy. Too many unknowns 
can throw their predictions off. 
4  Federal Reserve Bank of Minneapolis Quarterly Review/Winter 1978 One of the biggest uncertainties this year is 
business fixed investment. We have predicted that 
capital outlays in 1978 will be nearly as strong as in 
1977. But this may be too optimistic. Surveys of 
business spending intentions, the latest Commerce 
Department survey among them, show that busi-
ness plans to spend only 10 percent more this year 
on new plant and equipment. That small an increase 
would undercut our GNP forecast. 
Similarly, we have predicted 1978 consumer 
spending to be close to 1977
,s. But in doing so we 
have discounted the effect of sagging domestic auto 
sales on the economy because consumers have been 
buying other goods and services. If car sales don't 
pick up, though, and sales of other consumer items 
don't keep making up the difference, the projection 
for total production would be off. 
The economic impact of the tax cut is also uncer-
tain. We may have underplayed it in this forecast by 
assuming the tax cut will only be $25 billion. A 
larger cut would certainly have a larger effect on the 
economy, however. And some members of Congress 
are pushing for a $40 billion cut or fewer tax reforms 
than outlined in the Carter package. But even at $25 
billion we may have overplayed the impact of the tax 
cut; consumers and businesspeople may see it as in-
flationary and reserve spending decisions until they 
feel more confident about their economic futures. 
Another uncertainty not reflected in this forecast 
is oil price increases by the OPEC nations. Should 
large increases occur, of course, they would ring in a 
new round of inflation. 
And finally, but perhaps most important, we 
have discounted the economic disruptions in early 
1978. Retail sales, housing starts, and industrial 
production all slowed, mostly, we believe, because 
of the bad winter weather and the coal strike. If 
these slowdowns turn out to be more than tempo-
rary, however, due, perhaps, to more general eco-
nomic uncertainties, both our production and infla-
tion projections would be too optimistic. 
Just how much can the policy maker do? 
We are looking for a fairly strong economy in 1978. 
Yet we see no end to either the 6 percent unemploy-
ment rate or the 6 percent inflation rate. This is not a 
very pleasant prospect. Why aren't the policy 
makers doing something? Instead of the 6-6 fore-
casted, why aren't policies being formulated and 
implemented to give us a 4-4 combination? Or some-
thing even better? 
In the 1960s we saw a relationship between 
inflation and unemployment that led many to be-
lieve a trade-off exists: when the unemployment 
rate is low, the inflation rate will be high and vice 
versa (Chart 11). Many policy makers assumed their 
task was to choose a particular inflation-unemploy-
ment target and adopt policies to achieve it. 
But in the 1970s we have discovered that the 
trade-off apparently has disappeared. Inflation has 
not decreased as unemployment has increased. On 
Chart 11, the points from 1970 to 1977 do not form a 
downward sloping curve as the 1960-1969 points do. 
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Unemployment Rate 
(Unemployment as a percent of the labor force) 
This experience has caused a debate among 
economists as well as policy makers. 
Traditionalists maintain that the trade-off still 
exists, but that it has been thrown off by a number 
of special factors. The most obvious is the sharp rise 
in energy prices since 1973. But other factors such 
as the dollar's devaluation, weather, and environ-
mental regulations—factors independent of mone-
tary and fiscal policy—have also contributed to infla-
tion. Consequently, the traditionalists argue, the 
Chart 11 
Inflation vs. Unemployment 
actual 1960-77, projected 1978 
I I  . 1 
74 
I 
• 
75 
• 69 
78  • 
•73 
•70  •71 
77  • 
•76 
• 68 
• 72  -
• 66 
•67 
1 1 
65 
60.62 
64* \63 
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•61 
I 
5 policy maker can still exploit the unemployment-
inflation relationship; the target will just have to be 
different than in the 1960s. 
Nontraditionalists assert that a trade-off does 
not now, and never did, exist. They reason that 
since it's in the interest of workers and employers to 
anticipate government policies and act accordingly, 
they do. Therefore systematic monetary and fiscal 
stabilization policies can do little to move the econ-
omy in one direction or the other. 
The existence of the inflation-unemployment 
trade-off is obviously a critical issue for an economy 
with both inflation and unemployment around 6 
percent. Until it's resolved, finding the best policy 
to improve this situation will continue to be at least 
as uncertain as economic forecasting.* 
•A more thorough analysis of the inflation-unemployment 
trade-off follows in the speech by John Kareken. 
8 Federal Reserve Bank of Minneapolis Quarterly Review/Winter 1978 

The U.S. economy in 1977 and 1978

http://www.minneapolisfed.org/research/QR/QR211.pdf

The U.S. economy in 1977 and 1978

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