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"H E CHAIRMAN OF THE
C O UNCIL OF ECONOM'C AD VISE R S
WASHINGTON

March 14, 1978

MEMORANDUM FOR THE PRESIDENT
FROM:

Charlie Schultze G *-

SUBJECT:

Background on Inflation

0

Developments of the past 4 or 5 months have led to
some worsening of the outlook for inflation in 1978, as
I indicated to you orally about a week ago.
The time is
growing short for action to improve the chances that the
anti-inflation program announced in January will show
some results this year.
Your economic advisers are therefore
preparing a list of steps that might be taken.
A memo will
come to you within 'the next several days on the worsened
outlook for inflation in 1978 and on options to implement
the anti-inflation program.
This paper is designed to
provide you with some broad background on the nature of the
current inflation problem.
What Starts a New Inflation?
The forces that initiate an increase in the rate of
inflation fall into two broad categories:




o

The classic problem of inflation arises from excess
aggregate demand. When unemployment and unused
plant capacity are large, fairly rapid increases
in the demand for goods and services (on the part
of consumers, businessmen, and governments) result
mainly in putting idle labor and capital resources
back to work.
But once the nation is producing
at its "potential," further large increases in
demand give rise to inflationary pressures.
Labor
markets are tight, a n d '
the attempt by business firms
to continue large-scale hiring leads to accelerated
wage increases.
Strains on industrial capacity add
to costs, which can easily be passed on.
Shortages
develop.
With the demand for goods and services
outrunning productive capacity, business firms find
they can raise prices to increase their profit
margins, without fear that competitors with capacity
to spare will undercut them.

-2-

o

A variety of supply shocks, such as food shortages
or an OPEC oil price boost, may also increase costs
and prices and give rise to an acceleration of
inflation.
The impact of supply shocks on the
inflation rate will be greatest in periods of
high employment, when it is easier for business
firms to pass on the higher costs and for labor to
raise wages in order to keep up with the cost-ofliving.
But supply shocks will tend to push up
prices even in periods of substantial economic
slack.

The recent inflationary period has its distant origins
in the inflationary means used to finance the Vietnam War.
From 1965 through 1969, the economy was operating continuously
with real output above the nation's productive potential
(see Chart 1).
Unemployment during this period stayed below
4 percent, and was as low as 3-1/2 percent in late 1968 and
early 1969.
The result was a classic case of excess demand
inflation. Increases in wage rates and prices both began to
move up in late 1965 and continued to rise over the next
three years (Table 1).
By 1969, consumer prices were rising
at around 6 percent a year, compared with 2 percent in 1965.
Average wage rates, which were increasing at around 3-1/2
percent a year in 1965, were rising at a 6-1/2 percent rate
by 1969.
Table 1
Changes in Wage Rates and Prices
December to December
(Percent)
Average Hourly
Earnings
1965
1966
1967
1968
1969
1970




3.4
4.9
5.3
6.8
6.5
6.7

Consumer Prices
1.9
3.4
3.0
4.7
6.1
5.5

-3-

Chart 1
Actual and Potential GNP
Billions of 1972 Dollars (Ratio Scale)




-4-

Excess demand also was a contributing factor to a
renewed heating up of inflation in 1973.
The rate of
inflation had moderated substantially during the latter half
of 1971 and 1972, when mandatory price and wage controls
were in effect.
In 1972, however, both monetary and fiscal
policies were highly expansive, and real output grew strongly.
By 1973, real GNP reached its potential level (Chart 1) and
the unemployment rate was down to around 4-3/4 percent.
As
the controls on wages and prices were relaxed during the
course of 1973, inflationary pressures intensified.
A larger part of the 1973-74 acceleration of inflation,
however, stemmed from supply shocks.
The special factors
that influenced prices in those two years were of unprecedented
severity for a peace time period.
o

Retail food prices rose more than 30 percent in two
years, largely as a consequence of poor world-wide
harvests of major grain crops.

o

The OPEC oil price increase drove up energy prices
paid by consumers 40 percent in two years.

o

An economic boom in all industrial countries
simultaneously created major scarcities of critical
industrial materials.

o

The fall of almost 15 percent in the value of the
dollar in exchange markets from mid-1971 to mid-1973
on a bilateral trade-weighted basis raised import
prices substantially.

o

The phasing out and removal of wage and price
controls in late 1973 and early 1974 led to an
explosion of industrial commodity prices at the
wholesale level.

What Perpetuates Inflation, Once Started?
Removal of the initiating forces of inflation does not, '
unfortunately, mean that inflation comes to an end.
Once
underway, an inflationary process becomes deeply embedded in
the structure of wage, cost, and price increases, and
develops a momentum of its own.
Unwinding from a prolonged
inflation is extremely difficult.
i




-5-

If the rate of wage increases tapered off quickly as
unemployment rose, and if business firms' pricing policies
reflected the state of product markets, inflation could be
quickly brought under control.
A short period of slow
growth, with moderate increases in unemployment and idle
capacity and a weakening of markets for business sales,
would rapidly halt inflation.
Unfortunately, in modern economies, the behavior of
prices, and especially wages, is not very sensitive to
modest and short-lived periods of economic slack.
Once an
inflation has been underway for awhile, workers and employers
behave as if it will continue.
Wages increase in response
to past price increases and in the expectation that future
inflation will make it possible to pass on the higher wages
into higher prices.
The pattern is only modestly influenced
by the existence of high unemployment and excess capacity.
It therefore is very difficult to use the traditional tools
of monetary and fiscal policy to bring inflation to a halt
once it has begun in earnest.
Recent experience in two recessions illustrates the
problem.
In 1969, both monetary and fiscal policies moved
sharply toward restraint in an effort to break the back of
the excess demand inflation of 1965-69.
The shift in
monetary policy was particularly harsh.
The annual growth
rate of
dropped from 8 percent in the second half of
1968 to less than 3 percent in the last half of 1969.
Interest rates skyrocketed, and sources of housing finance
dried up.
The result was a recession that began late in
1969 and continued throughout 1970.
Unemployment rose from
3-1/2 percent to 6 percent.
Elimination of the excess demand, however, had no
effect on the rate of inflation.
The rise in the CPI did
slow temporarily, due to a decline in mortgage interest
rates, but the underlying forces pushing up costs and prices
were not affected.
Wage rates continued to rise as fast in
1970 as they had in 1969 (Table 1) .
The failure of wage and price increases to moderate
during 1970 occasioned widespread surprise and commentary.
The Nixon Administration, you may remember, advocat-ed a
policy of gradualism in dealing with inflation — in the
expectation that prices and wages would eventually respond
to high unemployment and excess capacity.
In the summer of
1971, this expectation was abandoned, and wage and price
controls were imposed.




-6 -

Experience since 1974 has been similar.
During the
first half of 1975, the rate of inflation did moderate
substantially from the hectic pace of the previous two
years.
By around mid-year 1975, price increases were down
to the 6 to 6-1/2 percent range.
The recession of 1974-75
was much more severe than the recession of 1970, and it did
have some tempering influence on wage and price behavior.
But the moderation of inflation in early 1975 stemmed mainly
from the termination of the special factors pushing up
prices and wages in 1973-74.
The late 1973 OPEC oil price
increase had largely worked its way through the economic
system; food supplies improved; the worldwide commodity boom
ended; and catch-up increases in prices and wages after the
removal of controls came to an end.
Since mid-1975, the economy has been operating with a
substantial degree of slack.
Excess capacity in manufacturing
has been widespread — the rate of capacity utilization has
yet to rise above 83 percent.
And the unemployment rate has
only recently declined to below 6-1/2 percent.
But, apart
from erratic movements in fuel and food prices, the inflation
rate has stubbornly persisted at a 6 to 6 - 1 / 2 percent rate.
Until very recently, there has been little or no
evidence that inflationary pressures were accelerating,
but neither has there been evidence of a slowing of
wage and price increases.
Since the middle of 1975,
total compensation (wages plus fringes) per hour worked
in the nonfarm business sector has been rising at an
annual rate of about 8-1/2 percent (Table 2).
The
long-term trend of productivity gains is now around
2 percent.
The long-term trend of unit labor costs since
mid-1975 has thus been rising at about a 6-1/2 percent rate,
and this has determined the underlying trend of consumer
prices.
The continuation of inflation in the range of 6 to
6-1/2 percent since mid-1975, it should be noted, is not
due to the size of the Federal deficit.
And it is not
due to excessive increases in supplies of money and credit.
Monetary and fiscal policies dq have an important bearing
on prices, but that effect is indirect — that is, they
affected prices by changing the balance between aggregate
demand and supply.
If monetary and fiscal policies since
1975 had been less expansive, aggregate demand would have




-7Table 2
Costs and Prices
Annual Rate of Change
(Percent)
Compensation
per hour
private nonfarm
sector
nd half

Consumer prices,
excluding food
- and fuel

4.6

6 . 1

1976 1st half
2 nd half

9.8
8.5

7.8
6.5

7.0

1977 1st half
2 nd half

9.6
7.5

7.6
5.5

6.7
5.9

Mid-1975 through
year-end 1977

6.4

6.4

1/

2

•

6 . 6

00

1975

Trend of
unit labor
costs I/

6 . 1

Based on 2 percent trend of productivity.

grown more slowly.
Perhaps some modest decline in the
inflation rate would have occurred had unemployment been
kept at a 7 or 7-1/2 percent rate.
The principal result,
however, would have been to constrain the growth of output
and employment rather than to reduce the rate of inflation.
Inflation has continued at around a 6 to 6-1/2 percent rate
not because aggregate demand has grown too rapidly, but
because the momentum of inflation is so strong.
Why is the Momentum Strong?
Many years ago, price and wage increases could be
counted on to moderate significantly in response to slack
in labor and product markets.
That is no longer the case.
Prices and wages are relatively inflexible in a downward
direction, so that economic slack no longer leads to a
significant moderation of inflation.
The result is that each new bout of inflation tends to
set a higher floor under the average rate of rise in wages
and prices.
Each new round of inflation starts from a
higher base, and the rate of inflation tends to drift upward
over long periods of time (Chart 2).




10

8

6

2

___I___ I___ I___ I___ I___ I_ 1
_ ___ I___I___1
___I___ L
I
52
55
58
61
64



-9 -

The factors that lead to downward inflexibility of
wages and prices are many and varied.
For example:
o

Price competition is limited in many sectors of
the economy.
Competition tends to focus on other
strategies than pricing, such as advertising and
variations in services.

o

Wage rate settlements in heavily unionized
industries are notoriously unresponsive to changes
in the rate of unemployment.
In 1977, for example,
the steel industry was in great difficulty and
imports were growing rapidly; but the contract
signed with the steel workers gave wage and fringe
benefit gains averaging about 9 - 1 / 2 percent a year
for three years, even though productivity has been
rising only about 1-1/4 percent per year in the
industry.

o

Union wage contracts are typically signed for
3 -year periods
and the majority contain formal
escalator clauses.
The ongoing rate of wage
change thus depends heavily on prior conditions
in labor markets and on the current rate of inflation,
rather than on the balance between demand and supply
for labor.
Moreover, the size of contracts signed
by one major union often tends to influence contracts
signed by others. One union leader can't be seen as
"weaker" than another.

o

Many firms in nonunionized industries pursue
long-range wage policies designed to maintain a
stable labor force.
Hence, they do not take
advantage of a temporary surplus of job applicants
to reduce wage increases significantly.

There is some evidence that the unresponsiveness of
wages and prices to economic slack may have become worse
during the postwar period.
Table 3 shows wage and price
developments during postwar business cycles.
Deceleration
of wages and prices — particularly of wages — has been
less and less evident in each succeeding economic contraction.
The table exaggerates the problem, since there were strong
outside forces pushing up prices and wages prior to the
1948-49 recession and again during the recent recession.




Table 3

Average hourly earnings index,
manufacturing!'

Cycle

At cyclical
peak

2 quar­
ters after
recession
trough

Change

Consumer price index

At cyclical
peak

2 quar­
ters after
recession
trough

Unemployment rate, v ^ a ^ v H S
salary workers in

Change

At cyclical
peak

Percent change from 4 quarters earlier

1948-49
1953-54
1957-58
1960-61
1969-70
1973-75

1/

9.1
5.8
5.0
3.1
6.0
6.6

1.9
2.4
3.6
2.6
6.8
9.5

-7.2
-3.4
-1.4
-.5
.8
2.9

4.5
.9
3.5
1.8
5.8
8.4

2 quar­
ters after
recession
trough

Change

4-quarter average

-0.6
-.6
1.9
1.2
4.4
8.7

-5.1
-1.5
-1.6
-.6
-1.4
.3

4.2
2.8
4.6
5.8
3.3
4.3

8.2
7.1
9.3
8.0
6.7
10.4

4.0
4.2
4.7
2.2
3.4
6.1

Adjusted for overtime and interindustry shifts.

Source:

Department of Labor, Bureau of Labor Statistics.




i
M
O
I

-11But some reduction in the degree of downward flexibility of
wages and prices — particularly wages — evidently has
occurred.
The reasons for this reduced downward flexibility of
wages and prices are not clear, but several factors may be
involved.
o

Formal escalator clauses in union wage contracts
have become much more widespread.

o

Expectations of continued inflation have also
become more widespread.
This may have stiffened
the resistance of workers to accept smaller
wage increases, even during periods of high
unemployment, while weakening the reluctance
of business firms to negotiate contracts that
will require price increases.

o

Better protection against income losses during
recessions — because of more liberal unemployment
insurance benefits and other income-maintenance
programs — may have blunted the effects of high
unemployment on wage rates.
Unemployed workers,
with better income protection, are not so prone to
accept work paying less than they earned in their
last job.

o

Employment in government, nonprofit establishments,
and regulated industries (utilities, communications,
and commercial transportation) has grown as a
proportion of total employment.
Wage rate
determination in those sectors is affected
relatively little by the overall rate of
unemp 1 oyment.

From time to time, proposals have been set forth
to deal with the problem of inflation by reducing the
sources of wage and price inflexibility.
Such proposals
typically involve massive change in the structure of
economic institutions — breaking up labor unions,
repealing the Davis-Bacon Act, abolishing the minimum
wage law, breaking up large firms, and so on.
Whether
such steps would actually succeed in reducing wage and
price inflexibility is a controversial issue.
What is
not controversial is the fact that radical steps in this
direction are far beyond the boundaries of political




-12feasibility.
Government actions to deal with inflation
must accept the existing degree of wage and price
inflexibility as a difficult fact of life.
Long-Range Prospects for Inflation
Unless we can find ways to unwind from the 6 to
- 1 / 2 percent inflation that is the legacy of the past,
the outlook for inflation over the longer run is not
good.
6

o

Government actions (payroll taxes, an energy
program, steps to achieve environmental and
safety objectives) are adding to costs, and
will continue to do so.
With a major effort
we can moderate some of these effects, but
cost-raising actions will undoubtedly continue.

o

Supply shocks that we cannot now foresee are
much more likely to increase costs and prices
than to reduce them.

o

As we regain high levels of employment and
production, the risks will increase that
tightening labor and product markets will
result in an acceleration of wage and price
increases.
In recent years, nonunion wages
have grown substantially less than union
wages; as unemployment is reduced, some catch-up
can be expected.

How much room we have to reduce unemployment and excess
capacity further before wages and prices begin to respond to
a tightening of markets is particularly difficult to assess.
The overall capacity utilization rate in manufacturing
is still relatively low — about 83 percent.
If our economic
forecast for 1978 and 1979 is realized, this rate will rise
to a range of 87 to 8 8 percent by late 1979.
Capacity
constraints are not likely to become a serious source of
price pressures during this period, however, in part because
of the availability of ample capacity abroad.
There will be
a longer-range capacity problem if business investment does
not rise strongly over the next few years, but that problem
is likely to be encountered in 1980 and beyond.




-13A s we move toward lower rates of unemployment,
increasing labor market tightness will, at some point
or other, lead to an acceleration in the rate of advance
in wages.
We cannot be sure at what point that will happen.
A decade ago, wages did not begin moving up until the
unemployment rate fell to around 4 percent or so.
But
changes in the demographic characteristics of the labor
force — in particular, the increased proportion of the
work force consisting of teenagers — and other factors
have raised considerably the rate of unemployment consistent
with a stable rate of wage increase.
The availability of
more generous unemployment insurance, and such income
supports as food stamps, may have raised the level of
unemployment at which wage increases begin to accelerate.
(As explained earlier, workers can be more choosy about the
jobs and wages they will accept.)
In 1973, wage rates began
to accelerate when the unemployment rate was around 5 percent.
Extensive studies done by CEA staff and by academic economists
yield a wide range of estimates of what the critical unemployment
rate might be at the present time.
It is probably in the
general neighborhood of 5 - 1 / 2 percent, but we cannot be sure
where the critical point is.
Effective and well-targeted programs to reduce structural
unemployment — especially among minorities — can reduce
the overall unemployment level at which inflation begins to
accelerate.
To the extent that such policies can direct
hiring by business and government toward those groups who
suffer from very high unemployment rates — rather than
toward groups already in short supply — upward wage and
price pressures would be eased.
The private employment
initiative now being developed is our attempt to do this.
But we cannot be sure how effective it will be.
There is some evidence — tentative and as yet
inconclusive — that a small acceleration in wage rates
is already underway.
A year ago, increases in average
hourly earnings (excluding fringes) were running at an
annual rate of around 7 percent.
Now the rate of increase
appears to be about 7 - 1 / 2 percent.
/

Forthcoming Memo
Shortly you will be receiving a memo from your economic
advisers which




o

revises the inflation outlook for 1978




-1 4 o

suggests some specific steps that might be taken
by the Federal Government, both to deal directly
with the inflation problem and to give greater
credibility to our voluntary program for
decelerating inflation in the private sector.


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102