August 9, 1992
"Casualties of the War - Inflation is a Sneaky Enemy; But If You're Going
to Endure the Pain of Battling It, Then Kill It Dead"
San Jose Mercury News
By Timothy Taylor
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A WAR IS being fought against inflation. You can't see the battle, but the
casualties are visible in slow economic growth and a rising unemployment rate.
The tough question, as in any conflict, is whether the rewards are worth the struggle.
I suspect that many Americans do not consider inflation in the range of 5 percent
or so to be a problem. After all, dim memories still linger of double-digit inflation
between 1979 and 1981; today's rates are less than half that level.
But as Saddam Hussein has taught, you don't defeat some enemies without killing
them altogether. Inflation at lower levels is less disruptive, less painful, and
less unfair, but those problems continue to exist.
For example, an annual inflation rate of 5 percent means that $1 today will buy
only half as much in 14 years, and a quarter as much in 28 years. Savers considering
their retirement or businesses considering long-term investments must first protect
themselves against inflation, and potential variations in inflation, and only
then concern themselves with purely economic criteria for investing. Inflation
creates economic nearsightedness, a difficulty in perceiving the future and planning
Inflation also redistributes income toward those who can find ways to protect
themselves from it. For example, homeowners have watched inflation push up the
value of their homes, while renters received no such gains. Social security payments
have risen with inflation for several decades, but welfare payments and many private
pension plans have not.
In the not-too-distant past, these arguments led a conservative, free-market
Republican president to take dramatic steps. Inflation rose from less than 2 percent
in the early 1960s to 3.1 percent in 1967 to 4.2 percent in 1968, 5.5 percent
in 1969 and 5.7 percent in 1970. President Nixon reacted by imposing national
wage and price controls in August 1971.
Inflation was sneaking up again in the late 1980s: 3.6 percent in 1987, 4.1
percent in 1988, 4.8 percent in 1989, 5.4 percent in 1990. As a result, the Federal
Reserve has been at cross purposes with itself throughout George Bush's presidency.
The Fed has been trying to push down interest rates and provide credit to help
stimulate the economy, but every such step has been taken with hesitation, since
spurring the economy too hard, too fast, could cause inflation to accelerate.
But inflation has now dropped to about 3 percent. Even better, most economists
would argue that zero inflation is too extreme a goal, because of difficulties
in measuring inflation. Conceptually, inflation should measure how much the cost
of buying a typical group of goods has changed. But the typical group of goods
itself keeps changing, especially as new and improved products enter the market.
Given the measurement problems, many economists would argue that an inflation
rate of 2 percent or less is functionally equal to zero. With inflation at 3 percent,
the economy appears close to that target. But appearances can be deceiving.
Killing inflation, instead of only wounding it, means that people must really
believe it is gone. But the Consumer Confidence Survey (of the Conference Board,
a business research group) reports that consumers are still expecting inflation
of 4.6 percent over the next 12 months, roughly the same level they were expecting
back before Bush took office.
People's expectations that inflation will rekindle have real impact. Expectations
of inflation affect demands for wage increases, and the level of price increase
that people are willing to accept. Once established in people's minds, inflation
has a self-sustaining momentum.
Expectations of higher inflation can be seen most clearly in the fact that
the interest rate on three-month Treasury bills is 3.2 percent while the rate
on long-term government bonds is about 7.4 percent. Investors are demanding a
higher long-term rate because they expect a resurgence of inflation, which will
make the interest they receive worth less. The gap between short-term and long-term
interest rates also explains why banks are now able to pay such low interest rates
on deposits (a short-term investment) but charge such high rates on mortgages
(a long-term investment).
How long will it take for inflationary expectations to shift? Here's one rule
of thumb used by economists: Reducing inflation permanently by 1 percentage point
requires slowing the economy by enough to raise unemployment by 2 percentage points
for one year. Slowing inflation from 5 percent to 2 percent means raising unemployment
by 6 percentage points for one year, 3 points for two years, or some similar combination.
Wringing It Out
Unemployment rose from 5.4 percent in 1990 to 6.6 percent in 1991 and is currently
in the range of 7.5 to 8 percent. So a rough extrapolation would predict another
year of unemployment at current levels before inflation is wrung out of the economy.
During the election campaign, Democrats will emphasize the high unemployment
rate. Republicans will respond that unraveling the inflation of the late 1970s,
which escalated under a Democratic president, was bound to be painful, and assert
that a stable foundation for long-term growth is now set.
While that argument rages, this fact remains. After slow growth for the last
few years, the economy has already absorbed most of the costs of reducing inflation.
At this point, it would be tragic if we didn't finish the job, and return to the
days when inflation was negligible.
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