"HE CHAIRMAN OF THE COUNCIL OF ECONOM'C ADVISERS WASHINGTON

Transcription

1 "HE CHAIRMAN OF THE COUNCIL OF ECONOM'C ADVISERS WASHINGTON March 14, 1978 MEMORANDUM FOR THE PRESIDENT FROM: Charlie Schultze G *- 0 SUBJECT: Backgrund n Inflatin Develpments f the past 4 r 5 mnths have led t sme wrsening f the utlk fr inflatin in 1978, as I indicated t yu rally abut a week ag. The time is grwing shrt fr actin t imprve the chances that the anti-inflatin prgram annunced in January will shw sme results this year. Yur ecnmic advisers are therefre preparing a list f steps that might be taken. A mem will cme t yu within 'the next several days n the wrsened utlk fr inflatin in 1978 and n ptins t implement the anti-inflatin prgram. This paper is designed t prvide yu with sme brad backgrund n the nature f the current inflatin prblem. What Starts a New Inflatin? The frces that initiate an increase in the rate f inflatin fall int tw brad categries: The classic prblem f inflatin arises frm excess aggregate demand. When unemplyment and unused plant capacity are large, fairly rapid increases in the demand fr gds and services (n the part f cnsumers, businessmen, and gvernments) result mainly in putting idle labr and capital resurces back t wrk. But nce the natin is prducing at its "ptential," further large increases in demand give rise t inflatinary pressures. Labr markets are tight, a n d 'the attempt by business firms t cntinue large-scale hiring leads t accelerated wage increases. Strains n industrial capacity add t csts, which can easily be passed n. Shrtages develp. With the demand fr gds and services utrunning prductive capacity, business firms find they can raise prices t increase their prfit margins, withut fear that cmpetitrs with capacity t spare will undercut them.

2 -2- A variety f supply shcks, such as fd shrtages r an OPEC il price bst, may als increase csts and prices and give rise t an acceleratin f inflatin. The impact f supply shcks n the inflatin rate will be greatest in perids f high emplyment, when it is easier fr business firms t pass n the higher csts and fr labr t raise wages in rder t keep up with the cst-fliving. But supply shcks will tend t push up prices even in perids f substantial ecnmic slack. The recent inflatinary perid has its distant rigins in the inflatinary means used t finance the Vietnam War. Frm 1965 thrugh 1969, the ecnmy was perating cntinuusly with real utput abve the natin's prductive ptential (see Chart 1). Unemplyment during this perid stayed belw 4 percent, and was as lw as 3-1/2 percent in late 1968 and early The result was a classic case f excess demand inflatin. Increases in wage rates and prices bth began t mve up in late 1965 and cntinued t rise ver the next three years (Table 1). By 1969, cnsumer prices were rising at arund 6 percent a year, cmpared with 2 percent in Average wage rates, which were increasing at arund 3-1/2 percent a year in 1965, were rising at a 6-1/2 percent rate by Table 1 Changes in Wage Rates and Prices December t December (Percent) Average Hurly Earnings Cnsumer Prices

3 -3- Chart 1 Actual and Ptential GNP Billins f 1972 Dllars (Rati Scale)

4 -4- Excess demand als was a cntributing factr t a renewed heating up f inflatin in The rate f inflatin had mderated substantially during the latter half f 1971 and 1972, when mandatry price and wage cntrls were in effect. In 1972, hwever, bth mnetary and fiscal plicies were highly expansive, and real utput grew strngly. By 1973, real GNP reached its ptential level (Chart 1) and the unemplyment rate was dwn t arund 4-3/4 percent. As the cntrls n wages and prices were relaxed during the curse f 1973, inflatinary pressures intensified. A larger part f the acceleratin f inflatin, hwever, stemmed frm supply shcks. The special factrs that influenced prices in thse tw years were f unprecedented severity fr a peace time perid. Retail fd prices rse mre than 30 percent in tw years, largely as a cnsequence f pr wrld-wide harvests f majr grain crps. The OPEC il price increase drve up energy prices paid by cnsumers 40 percent in tw years. An ecnmic bm in all industrial cuntries simultaneusly created majr scarcities f critical industrial materials. The fall f almst 15 percent in the value f the dllar in exchange markets frm mid-1971 t mid-1973 n a bilateral trade-weighted basis raised imprt prices substantially. The phasing ut and remval f wage and price cntrls in late 1973 and early 1974 led t an explsin f industrial cmmdity prices at the whlesale level. What Perpetuates Inflatin, Once Started? Remval f the initiating frces f inflatin des nt, ' unfrtunately, mean that inflatin cmes t an end. Once underway, an inflatinary prcess becmes deeply embedded in the structure f wage, cst, and price increases, and develps a mmentum f its wn. Unwinding frm a prlnged inflatin is extremely difficult. i

5 -5- If the rate f wage increases tapered ff quickly as unemplyment rse, and if business firms' pricing plicies reflected the state f prduct markets, inflatin culd be quickly brught under cntrl. A shrt perid f slw grwth, with mderate increases in unemplyment and idle capacity and a weakening f markets fr business sales, wuld rapidly halt inflatin. Unfrtunately, in mdern ecnmies, the behavir f prices, and especially wages, is nt very sensitive t mdest and shrt-lived perids f ecnmic slack. Once an inflatin has been underway fr awhile, wrkers and emplyers behave as if it will cntinue. Wages increase in respnse t past price increases and in the expectatin that future inflatin will make it pssible t pass n the higher wages int higher prices. The pattern is nly mdestly influenced by the existence f high unemplyment and excess capacity. It therefre is very difficult t use the traditinal tls f mnetary and fiscal plicy t bring inflatin t a halt nce it has begun in earnest. Recent experience in tw recessins illustrates the prblem. In 1969, bth mnetary and fiscal plicies mved sharply tward restraint in an effrt t break the back f the excess demand inflatin f The shift in mnetary plicy was particularly harsh. The annual grwth rate f drpped frm 8 percent in the secnd half f 1968 t less than 3 percent in the last half f Interest rates skyrcketed, and surces f husing finance dried up. The result was a recessin that began late in 1969 and cntinued thrughut Unemplyment rse frm 3-1/2 percent t 6 percent. Eliminatin f the excess demand, hwever, had n effect n the rate f inflatin. The rise in the CPI did slw temprarily, due t a decline in mrtgage interest rates, but the underlying frces pushing up csts and prices were nt affected. Wage rates cntinued t rise as fast in 1970 as they had in 1969 (Table 1). The failure f wage and price increases t mderate during 1970 ccasined widespread surprise and cmmentary. The Nixn Administratin, yu may remember, advcat-ed a plicy f gradualism in dealing with inflatin in the expectatin that prices and wages wuld eventually respnd t high unemplyment and excess capacity. In the summer f 1971, this expectatin was abandned, and wage and price cntrls were impsed.

6 - 6 - Experience since 1974 has been similar. During the first half f 1975, the rate f inflatin did mderate substantially frm the hectic pace f the previus tw years. By arund mid-year 1975, price increases were dwn t the 6 t 6-1/2 percent range. The recessin f was much mre severe than the recessin f 1970, and it did have sme tempering influence n wage and price behavir. But the mderatin f inflatin in early 1975 stemmed mainly frm the terminatin f the special factrs pushing up prices and wages in The late 1973 OPEC il price increase had largely wrked its way thrugh the ecnmic system; fd supplies imprved; the wrldwide cmmdity bm ended; and catch-up increases in prices and wages after the remval f cntrls came t an end. Since mid-1975, the ecnmy has been perating with a substantial degree f slack. Excess capacity in manufacturing has been widespread the rate f capacity utilizatin has yet t rise abve 83 percent. And the unemplyment rate has nly recently declined t belw 6-1/2 percent. But, apart frm erratic mvements in fuel and fd prices, the inflatin rate has stubbrnly persisted at a 6 t 6-1 / 2 percent rate. Until very recently, there has been little r n evidence that inflatinary pressures were accelerating, but neither has there been evidence f a slwing f wage and price increases. Since the middle f 1975, ttal cmpensatin (wages plus fringes) per hur wrked in the nnfarm business sectr has been rising at an annual rate f abut 8-1/2 percent (Table 2). The lng-term trend f prductivity gains is nw arund 2 percent. The lng-term trend f unit labr csts since mid-1975 has thus been rising at abut a 6-1/2 percent rate, and this has determined the underlying trend f cnsumer prices. The cntinuatin f inflatin in the range f 6 t 6-1/2 percent since mid-1975, it shuld be nted, is nt due t the size f the Federal deficit. And it is nt due t excessive increases in supplies f mney and credit. Mnetary and fiscal plicies dq have an imprtant bearing n prices, but that effect is indirect that is, they affected prices by changing the balance between aggregate demand and supply. If mnetary and fiscal plicies since 1975 had been less expansive, aggregate demand wuld have

7 -7- Table 2 Csts and Prices Annual Rate f Change (Percent) Cmpensatin per hur private nnfarm sectr Trend f unit labr csts I/ Cnsumer prices, excluding fd -and fuel nd half st half nd half st half nd half Mid-1975 thrugh year-end / Based n 2 percent trend f prductivity. grwn mre slwly. Perhaps sme mdest decline in the inflatin rate wuld have ccurred had unemplyment been kept at a 7 r 7-1/2 percent rate. The principal result, hwever, wuld have been t cnstrain the grwth f utput and emplyment rather than t reduce the rate f inflatin. Inflatin has cntinued at arund a 6 t 6-1/2 percent rate nt because aggregate demand has grwn t rapidly, but because the mmentum f inflatin is s strng. Why is the Mmentum Strng? Many years ag, price and wage increases culd be cunted n t mderate significantly in respnse t slack in labr and prduct markets. That is n lnger the case. Prices and wages are relatively inflexible in a dwnward directin, s that ecnmic slack n lnger leads t a significant mderatin f inflatin. The result is that each new but f inflatin tends t set a higher flr under the average rate f rise in wages and prices. Each new rund f inflatin starts frm a higher base, and the rate f inflatin tends t drift upward ver lng perids f time (Chart 2).

8 I I I I I I 1 I I 1 I L I

9 - 9 - The factrs that lead t dwnward inflexibility f wages and prices are many and varied. Fr example: Price cmpetitin is limited in many sectrs f the ecnmy. Cmpetitin tends t fcus n ther strategies than pricing, such as advertising and variatins in services. Wage rate settlements in heavily uninized industries are ntriusly unrespnsive t changes in the rate f unemplyment. In 1977, fr example, the steel industry was in great difficulty and imprts were grwing rapidly; but the cntract signed with the steel wrkers gave wage and fringe benefit gains averaging abut 9-1 / 2 percent a year fr three years, even thugh prductivity has been rising nly abut 1-1/4 percent per year in the industry. Unin wage cntracts are typically signed fr 3 -year perids and the majrity cntain frmal escalatr clauses. The nging rate f wage change thus depends heavily n prir cnditins in labr markets and n the current rate f inflatin, rather than n the balance between demand and supply fr labr. Mrever, the size f cntracts signed by ne majr unin ften tends t influence cntracts signed by thers. One unin leader can't be seen as "weaker" than anther. Many firms in nnuninized industries pursue lng-range wage plicies designed t maintain a stable labr frce. Hence, they d nt take advantage f a temprary surplus f jb applicants t reduce wage increases significantly. There is sme evidence that the unrespnsiveness f wages and prices t ecnmic slack may have becme wrse during the pstwar perid. Table 3 shws wage and price develpments during pstwar business cycles. Deceleratin f wages and prices particularly f wages has been less and less evident in each succeeding ecnmic cntractin. The table exaggerates the prblem, since there were strng utside frces pushing up prices and wages prir t the recessin and again during the recent recessin.

10 Table 3 Average hurly earnings index, manufacturing!' Cnsumer price index Unemplyment rate, v ^ a ^ v H S salary wrkers in Cycle At cyclical peak 2 quarters after recessin trugh Change At cyclical peak 2 quarters after recessin trugh Change At cyclical peak 2 quarters after recessin trugh Change Percent change frm 4 quarters earlier 4-quarter average / Adjusted fr vertime and interindustry shifts. Surce: Department f Labr, Bureau f Labr Statistics. i M O I

11 -11- But sme reductin in the degree f dwnward flexibility f wages and prices particularly wages evidently has ccurred. The reasns fr this reduced dwnward flexibility f wages and prices are nt clear, but several factrs may be invlved. Frmal escalatr clauses in unin wage cntracts have becme much mre widespread. Expectatins f cntinued inflatin have als becme mre widespread. This may have stiffened the resistance f wrkers t accept smaller wage increases, even during perids f high unemplyment, while weakening the reluctance f business firms t negtiate cntracts that will require price increases. Better prtectin against incme lsses during recessins because f mre liberal unemplyment insurance benefits and ther incme-maintenance prgrams may have blunted the effects f high unemplyment n wage rates. Unemplyed wrkers, with better incme prtectin, are nt s prne t accept wrk paying less than they earned in their last jb. Emplyment in gvernment, nnprfit establishments, and regulated industries (utilities, cmmunicatins, and cmmercial transprtatin) has grwn as a prprtin f ttal emplyment. Wage rate determinatin in thse sectrs is affected relatively little by the verall rate f unemp1 yment. Frm time t time, prpsals have been set frth t deal with the prblem f inflatin by reducing the surces f wage and price inflexibility. Such prpsals typically invlve massive change in the structure f ecnmic institutins breaking up labr unins, repealing the Davis-Bacn Act, ablishing the minimum wage law, breaking up large firms, and s n. Whether such steps wuld actually succeed in reducing wage and price inflexibility is a cntrversial issue. What is nt cntrversial is the fact that radical steps in this directin are far beynd the bundaries f plitical

12 -12- feasibility. Gvernment actins t deal with inflatin must accept the existing degree f wage and price inflexibility as a difficult fact f life. Lng-Range Prspects fr Inflatin Unless we can find ways t unwind frm the 6 t 6-1 / 2 percent inflatin that is the legacy f the past, the utlk fr inflatin ver the lnger run is nt gd. Gvernment actins (payrll taxes, an energy prgram, steps t achieve envirnmental and safety bjectives) are adding t csts, and will cntinue t d s. With a majr effrt we can mderate sme f these effects, but cst-raising actins will undubtedly cntinue. Supply shcks that we cannt nw fresee are much mre likely t increase csts and prices than t reduce them. As we regain high levels f emplyment and prductin, the risks will increase that tightening labr and prduct markets will result in an acceleratin f wage and price increases. In recent years, nnunin wages have grwn substantially less than unin wages; as unemplyment is reduced, sme catch-up can be expected. Hw much rm we have t reduce unemplyment and excess capacity further befre wages and prices begin t respnd t a tightening f markets is particularly difficult t assess. The verall capacity utilizatin rate in manufacturing is still relatively lw abut 83 percent. If ur ecnmic frecast fr 1978 and 1979 is realized, this rate will rise t a range f 87 t 8 8 percent by late Capacity cnstraints are nt likely t becme a serius surce f price pressures during this perid, hwever, in part because f the availability f ample capacity abrad. There will be a lnger-range capacity prblem if business investment des nt rise strngly ver the next few years, but that prblem is likely t be encuntered in 1980 and beynd.

13 -13- A s we mve tward lwer rates f unemplyment, increasing labr market tightness will, at sme pint r ther, lead t an acceleratin in the rate f advance in wages. We cannt be sure at what pint that will happen. A decade ag, wages did nt begin mving up until the unemplyment rate fell t arund 4 percent r s. But changes in the demgraphic characteristics f the labr frce in particular, the increased prprtin f the wrk frce cnsisting f teenagers and ther factrs have raised cnsiderably the rate f unemplyment cnsistent with a stable rate f wage increase. The availability f mre generus unemplyment insurance, and such incme supprts as fd stamps, may have raised the level f unemplyment at which wage increases begin t accelerate. (As explained earlier, wrkers can be mre chsy abut the jbs and wages they will accept.) In 1973, wage rates began t accelerate when the unemplyment rate was arund 5 percent. Extensive studies dne by CEA staff and by academic ecnmists yield a wide range f estimates f what the critical unemplyment rate might be at the present time. It is prbably in the general neighbrhd f 5-1 / 2 percent, but we cannt be sure where the critical pint is. Effective and well-targeted prgrams t reduce structural unemplyment especially amng minrities can reduce the verall unemplyment level at which inflatin begins t accelerate. T the extent that such plicies can direct hiring by business and gvernment tward thse grups wh suffer frm very high unemplyment rates rather than tward grups already in shrt supply upward wage and price pressures wuld be eased. The private emplyment initiative nw being develped is ur attempt t d this. But we cannt be sure hw effective it will be. There is sme evidence tentative and as yet incnclusive that a small acceleratin in wage rates is already underway. A year ag, increases in average hurly earnings (excluding fringes) were running at an annual rate f arund 7 percent. Nw the rate f increase appears t be abut 7-1 / 2 percent. Frthcming Mem Shrtly yu will be receiving a mem frm yur ecnmic advisers which revises the inflatin utlk fr 1978 /

14 suggests sme specific steps that might be taken by the Federal Gvernment, bth t deal directly with the inflatin prblem and t give greater credibility t ur vluntary prgram fr decelerating inflatin in the private sectr.