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- H E CHAIRM AN OF THE COUNCIL OF E C O N O M IC ADVISERS WASHI NG' ON March 15, 1978 MEMORANDUM FOR THE PRESIDENT From W. Michael BlumenthalJ, Charlie Schultze ' U i • ? Subject: Price Prospects and Anti-Inflation Initiatives Earlier this week the CEA sent you a background memorandum on inflation. At the Cabinet meeting on March 6 , Secretary Blumenthal stressed that the inflation situation is worsening. This memorandum outlines our present expectations for prices in 1978 and sets forth a series of policy options for invigorating the anti inflation program. The specific policy options outlined below have not yet been cleared with all EPG members, but the general ideas expressed in this memorandum were discussed at a recent EPG meeting. We would, therefore, want to get together with you as soon as possible to discuss the inflation problem and what should be done about it. Recent Price Developments The price outlook is deteriorating. Weather influences contributed to some of the sharp rise in consumer food prices in January. But a more fundamental worsening of the outlook also appears to be underway. In preparing for the Budget and Economic Message this year, the interagency forecasting team balanced two offsetting developments: o An acceleration in the underlying rate of inflation based mainly on higher payroll costs due to (i) increased employer social security taxes, and (ii) higher minimum wages. o An expected slower growth in farm and food prices. -2The underlying rate of inflation was expected to be in the 6-1/2 to 6-3/4 percent range, but with food prices rising moderately, the overall consumer price index was forecast to rise by 6 to 6-1/4 percent, fourth quarter 1977 to fourth quarter 1978. Since these estimates were put together, a number of developments have all moved in the direction of increasing the prospective rate of inflation. o Food prices will probably rise more than forecast. Whereas the forecast had included a rise in the food component of the CPI of about 4-1/2 percent (QIV to QI V ) , we would now expect an increase of around 5-1/2 percent, or possibly more. This would add about 0 . 2 percentage point to the overall price increase in 1978. o The forecast made no allowance for the price effects in 1978 of depreciation of the doll a r . Allowance for this might result in a rise of prices of about half of 1 percent by the end of the year, assuming no further depreciation. o Average hourly earnings are creeping up. They are now rising at about one-half percent faster than a year ago. Moreover, the higher wage costs in the coal settlement, as they carry forward into industrial and residential utility rates and steel production costs, would add to overall prices. Unit labor costs will rise somewhat more than expected. o The forecast had incorporated the National Energy Plan, which would have yielded a 0.2 percent rise in overall prices as a result of the crude oil equalization tax. The likely compromise on natural gas deregulation may increase energy prices somewhat more, but how much is not clear at this time. Overall, it appears that consumer prices might rise about 1 percent more than had been expected, bringing the increase in the CPI during 1978 to the 7 to 7-1/4 percent range. -3There is considerable risk that prices may rise even faster than this. For example, the new estimate does not assume any OPEC price increase in response to the changing value of the dollar, nor does it assume further adverse weather conditions here or abroad, nor a marked acceleration in unit labor costs, nor ripple effects of the coal settlement on other wage negotiations. Consequences Rising inflation and inflationary expectations are already working on financial markets, domestic and international. They are contributing to the continued weakness of the dollar and the stock market. Inflation would, by now, have been reflected more strongly in interest rates, were it not for the relatively calm behavior of the monetary aggregates in recent weeks. As it is, the rise in market interest rates has already begun to reduce savings inflows to thrift institutions, and the thrifts have begun to trim new mortgage lending commitments. A continued rapid rise in prices will convince market participants that monetary tightening is in prospect, whatever the course of the monetary aggregates. This conviction could push interest rates up further, even without Fed action. Moreover, it is doubtful that the Fed would resist reinforcing the market's response in the event of further price acceleration. In sum, absent other convincing anti-inflation programs, the classic resolution of the inflation problem is likely to take the form of tightening financial markets, even with the Federal Reserve lagging rather than leading the market. Anti-Inflation Initiatives In light of these price developments and potential consequences, we believe that it is imperative that you act decisively to focus greater'attention on the anti inflation program. We recommend an announcement of a series of actions that would demonstrate your concern and commitment to achieving progress against inflation. It is important that these actions go beyond exhortation; they must have a direct impact on prices and wages. -4- o o A voluntary restraint program cannot be effective unless it has your visible support and backup by all Cabinet-level officers. o I. The deceleration program will not be credible unless the government acts within its own areas of responsibility to initiate a deceleration. It is necessary that developments in the coal situation do not set a pattern for future wage and price behavior. Immediate Action We propose that the following items be the basis for a Presidential announcement on inflation, perhaps at the opening of a press conference. 1. You could announce that the Federal government will assure that there is a significant deceleration in the magnitude of Federal pay increases. The 1976 increase was 5 percent; increase was 7 percent. the 1977 Federal employees have not been impacted by the recent large increase in social security taxes. Deceleration would therefore not be a major burden on them. Federal wage rate adjustments are believed to have a substantial impact on local labor markets. This action would be well received by the public, but may anger Federal workers and could reduce their support for Civil Service reform. 2. You could ask state and local government officials to follow the lead of the Federal government with respect to wage rate increases, and to cooperate further by reducing sales and property taxes where possible. These government actions on wages would have a strong impact on nonunion wage increases throughout the economy. They will probably upset organized labor. -5- 3. You could request the support of public utility commissions and the independent regulatory agencies in the deceleration objective. This may irritate a few members of Congress who object to Executive Branch involvement with the independent agencies. It may lengthen the regulatory delay on rate adjustments. 4. You could announce that your Executive Order on Improving Government Regulation will be issued the following day. This program has been delayed for three months, but is ready if your approval were given. It would be received very positively by the business community. At the same time, you could announce that you are meeting personally with the heads of the executive regulatory agencies to impress on them the importance of assuring that new regulations are necessary and that they are cost-effective. 5. You could emphasize the importance of moderating increases in hospital costs and ask the Congress to act immediately on your hospital cost contain ment and capital budgeting program. 6 . You could instruct Federal procurement officers to avoid or delay purchase of those goods whose prices are rising rapidly. Such a directive is not unprecedented, but care would have to be taken to avoid conflict with other objectives of procurement policies. 7. You could direct your advisors and heads of the affected agencies to develop a program, and report back to you within a month, for an early resolution of Federal policies toward wilderness a r e a s , to expand the lumber supply from Federal lands. Lumber prices have been a very rapidly rising component of housing costs (17.9 percent in the last year). -6 - While this would be a controversial action with environmentalists, it is believed that an expansion of timber harvest from Federal lands could be achieved without damaging environmental or other multiple-use objectives. Any public announcement should be preceded by consultation with Secretary Bergland. 8 . You could follow up these actions by calling separate meetings with businessmen and labor leaders to ask them to reduce the rate of their price and wage rate increases, including increases in "highly visible" executive pay. This would emphasize the deceleration principle at the level of individual decisions in the private sector. Cabinet-level officials and CWPS staff could follow up with meetings with individual firms, large employers and labor union leaders. II. Future Administration Decisions If you decide to press the anti-inflation program, inflation concerns will be a major issue in several future decisions. Thus, it is important that you be aware of the implications of highlighting the inflation issue. Farm Legislation Any future actions to respond to the farm strike by raising price supports, reducing production, or restricting imports will have an immediate impact on prices. National Health Insurance The financing and cost incentive aspects of any proposal could have major inflationary implications. Welfare Reform The Administration is under pressure to raise the wage rate for public service jobs. This will impact on the lower range of local wage scales. -7Trade Restrictions Currently, requests are before the ITC or STR for trade restrictions on copper, CB radios, zinc, and special steel products. The steel industry has pushed for an upward revision of the steel reference prices. The MTN trade negotiations have major price implications as domestic industries push for exemption from tariff reductions. Regulatory Actions The Administration will be making decisions on regulatory actions and legislation during 1978 with very significant potential for cost and price increases. Social Security Legislation A number of proposals are coming up in the Congress to restructure social security financing in order to mitigate the tax increases recently enacted. Some would have anti-inflationary benefits; others would not. The relation of reductions in social security taxation to the objectives of the tax reduction and reform program have to be considered carefully. III. Actions in Specific Sectors We are in the process of developing a specific list of economic sectors in which we will concentrate our efforts over the next year to reduce inflationary pressures. Interagency task forces would be established to examine alternative strategies for altering price-cost behavior in those industries where we feel that government participation can make a difference. These areas would include the primary metals industries, transportation, medical care, housing and insurance. We could implement our prior plans to meet with individual firms and unions to emphasize the deceleration objectives and to monitor their performance. o We could examine the merits of Administration support for no fault insurance. -8o OMB could be asked to set up a special unit to develop procedures for establishing a "regulatory budget" that would measure the costs entailed in achieving the social objectives of regulation. Consideration could be given to the subsequent creation of a Congressional/Executive Branch commission for joint actions in this area.