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.

Chipping Away
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 for it.

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. What's typical?

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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