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MEMORANDUM FOR THE PRESIDENT
From:

-

■1

Charlie Schultze
W. Michael Blumenthal

;ion
Subject:^ Prospect and Policies for Inflation Over th§
^
y ' Next Several Years
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During the past several months, a growing concern

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has developed around the country about the outlook for
inflation.
the

Your April 11 announcement of steps to implement

anti-inflation program was an important step in

dealing with the inflation problem.

Realistically,

however, the chances are no better than 50-50 that the anti­
inflation program will lead to a significant moderation of
wage and price increases —

even if it is followed up

vigorously and continuously.

A major question remains, therefore,

as to the

prospects for inflation and the appropriate course of
public policy to deal with the longer-term inflationary problem.

The increased public concern about inflation appears
to stem largely from the recent sharp increases in food
prices and the deterioration in the 197 8 food price outlook,
and to a lesser extent from the expected price effects of
the depreciation of the dollar in exchange markets.

The

worsening of inflation stemming from these sources is likely to
be transitory and of much smaller proportions than the effects
of special factors that drove up the inflation rate in 1973
and 1974.




- 2 As yet,

it is not certain that a significant

acceleration of the underlying

rate of inflation has occurred —

although, as indicated below, some disturbing signs have
emerged.

Nevertheless, there are compelling reasons for giving

substantially greater priority to

controlling inflation in

economic policy decisions:




o

The underlying rate of
decelerated.

The

6

price increase has clearly not

to 6-1/2 percent rate prevailing since

mid-1975 is unacceptable economically and is politically
damaging.

The American people are deeply concerned

about the current inflation problem.

o

The unemployment has declined from about
7-1/2 percent a year ago to
presently —

about 6-1/4 percent

more improvement than we had expected.

A further reduction, to the neighborhood of 5-1/2 - 5-3/4
percent, is likely to occur over the next two years if our
forecast of real GNP growth is realized. As unenplgyment declines, it
makes good sense to give increasing weight to
control of inflation.

o

As slack in labor and product markets decreases with
a rising level of economic activity,

the balance

of risks increasingly shifts toward greater danger
of acceleration.

A dramatic acceleration of inflation




- 3 -

appears unlikely, but preventing a moderate,
but steady, rise in the inflation rate will require
constant vigilance and great care in the formulation
of budgetary and other economic policies.

o

A significant increase in the underlying inflation
rate from present levels would have very serious
economic and political consequences.

Pressures in financial markets would intensify
greatly, and economic growth would slow.

Achievement of our basic economic goals
would be set back a number of years.

A recession at the time of the 1980 election,
together with an inflation rate considerably
higher than at present, cannot be ruled out.

The dollar could continue to decline in
foreign exchange markets, aggravating the
inflation further and creating serious
tensions between the U.S. and our trading
partners.

- 4 -

The time has therefore come to reexamine our long-term
macroeconomic policy strategy and to consider whether,
and to what degree, changes are needed to come to grips with
inflation.

The Administration's Long-Term Program for Dealing with Inflation

As background, it may be helpful to sketch the broad
outlines of our overall strategy for dealing with inflation,
and to consider what we know at the moment about the
success of that strategy.

A year ago, we set for ourselves ambitious economic goals
and embarked on a course of

policy to realize them.

We have always recognized that achievement of a 4-3/4 to 5
percent unemployment rate by 1981 carried a potential threat to
inflation. Our budgetary strategy was designed to move us
gradually toward those goals, with the hope that a new round
of inflation would not be touched off.

However, we have

always recognized the possibility that inflation could begin
to creep up before those rates of resource utilization were
reached.

The point at which wage and price

increases begin to accelerate in response to




reduced slack in labor and product markets remains an
unresolved issue.
Our policy strategy for dealing with the threat of inflation
has three principal elements:
1.

A program to unwind from the

6

to 6-1/2 percent under­

lying rate of inflation that we inherited from the past.
The April 1977 anti-inflation program was designed to
accomplish this objective,

as was the deceleration program

announced this past January.
2.

Efforts to reduce the potential for price shocks and to
minimize the direct contribution of government actions
to increases in costs and prices.

3.

Measures,

such as jobs and training programs,to

provide work opportunities for the disadvantaged,

in the

process, we hope to decrease the rate of unemployment
at which wage rates begin t o .accelerate.
Steps taken to implement the April 1977 anti-inflation program
were

not vigorous,

and the underlying rate of inflation did

not decelerate.
Our

efforts to reduce the governments' own direct contribution

to raising costs or prices, and to

reducing the potential for

exogenous price shocks, has also been relatively unsuccessful.
In a few areas, we have made progress.
down;

Airline fares have come

farmer-held grain reserves are being built up, and

safety and health regulations promulgated by OSHA have been
reduced in number.

But increases in payroll

taxes are adding materially to business costs, as is the rise
in the minimum wage, and protection from foreign competition




-

has been

6 -

extended to a number of industries. . Actions that we took, or to

which we acquiesced, in these areas may have been difficult to
avoid.

But we have not made the progress we had hoped

for.

The various jobs and training programs we have introduced
as a means of reducing the rate of unemployment at which
pressures on wage rates begin to develop
may succeed.
programs —

Several of the important new
the $400 million private sector

initiative in the FY 1979 budget, the jobs program in .welfare
reform,

"soft" public works and the employment tax

credit in the

urban policy proposal, have yet to get underway.

There is no doubt that these programs will add to employment
and increase job opportunities for the structurally unemployed.
But whether they do so in ways that reduce unemployment
among minorities and teenagers without putting upward pressure
on wage rates is still an open question.

We will

not know

for a couple of years whether, or to what degree, we have been
successful.
Recent Price and Wage Developments
In light of the lack of progress On the inflation front to
date,

the outlook

for inflation at the present time is

worse than had been expected.

The principal factors

that have led to larger prices in recent months

(the runup of

meat prices and the effects of the depreciation of the dollar)




-

are not the principal worry.

7

-

Their effects on the inflation

rate will be confined largely to 1978.

There could be

some spillover effect on wages and prices in 1979, but those
effects would be manageable.

The main source of concern

is that wage rate and cost increases may already be moving
up because of competitive bidding for labor.
The best single measure of wage rates is the index of
average hourly earnings in the nonfarm business sector.

That

index adjusts for changes in the mix of employment between
high and low wage industries and for changes in overtime in
manufacturing.

Increases in average hourly earnings

(see

table) decelerated in 1975 and 1976 and then stayed relatively
constant at 7 to 7-1/4 percent through the first 3 quarters
of 1977.

The year-over-year increase moved up to 7-3/4

percent in the fourth quarter of last year and to

8

percent

in the first quarter of this year.
Percent Increase in the Index of Average Hourly Earnings
(change from a year earlier)




1975 Q1
Q2
Q3
Q4

9.7
9.1

1976 Q1
Q2
Q3
Q4

7.7
7.5
7.2

1977 Q1
Q2
Q3
Q4

7.1
7.1
7.3
7.7

1978 Q1

8 . 0

8 . 6
8 . 2

6 . 8

^

'

- 8 There are two special factors that could account for
most or all of the wage rate acceleration in 1977:
(1)

The rise in the overall CPI moderated sub­
stantially in 1976, due to stability of food prices,
and then accelerated last year as food prices
rose sharply.

Because of cost-of-living adjustment

clauses in labor contracts, and informal arrange­
ments some employers have to relate wage rate
increases to movements in the CPI, this pattern
of consumer price changes would be mirrored in
wage rate behavior.
(2)

The January 1, 1978 increase in the minimum wage
may have affected wage changes in the private
sector late in 1977.

Some employers anticipate

changes in the minimum wage so that they get the
credit for increasing their employees' wages.
If these two factors explained all of the acceleration
in wage rates during 1977,

some deceleration in wage

increases might occur this year.
be sure that this is the case.

Unfortunately, we cannot
There is a possibility that

labor markets have already tightened enough —
the overall unemployment rate is still above

even though
6

percent —

so

that wage rates are now coming under pressure from
competitive bidding by employers for workers with better skills
and training.

In that event, a further decline in unemployment

would lend to a continued creeping up of the increase in
wages, costs and prices.




-

9 -

^ ^ ^ e Outlook for Inflation
The outlook for inflation thus hinges importantly on
the interpretation of recent wage rate developments and what
they mean for the underlying rate of inflation.

Our best

judgment is that unless the deceleration program is successful,
increases in wage rates are likely to continue moving up over
the next several years

if our goals for economic growth and

J
reduced unemployment are realized.
Based on past history, wage acceleration is likely to
be a slow and gradual process. Wage rates and unit labor costs
—

and hence the underlying inflation rate —

might move

up at something like 1/4 to 1/2 percent per year.
time,

At the present

the underlying inflation rate appears to be at the

end of a

6

to

6

-1 / 2

upper

percent range, and it could be higher.

Upward movement at 1/4 percent a year would put the underlying
rate in the 7 percent range by the end of 1979 and the 7-1/4
percent range by the end of 1980.

A 1/2 percent increase per year

would mean a 7-1/2 percent rate by the end of 1979 and
by the end of 1980.

A 7 to

8

8

percent

percent range for the underlying

rate of inflation during 1980 is thus a reasonable expectation
if the anti-inflation program is unsuccessful.
Wage and price developments could turn out better than
this if projections of some large econometric models are
correct.

For example, Data Resources Incorporated, one of the

most well known econometric forecasting services,




is presently

forecasting an inflation rate in the

6

to

6

-1 / 2

percent

range through 1980; the Wharton forecasting service expects
a gradual rise to about a 7 percent inflation rate by 1980.
There is also a risk, however,

that inflation may heat

up more than our best-guess estimate:
o

If the wage settlement in coal becomes a
pattern for the teamsters and other
large contracts expiring in 1979, wage rate
increases could accelerate sharply,

o

If the dollar continues to decline in exchange
markets, there could be continuing pressures
from this source on the domestic price level in 1979.

o

Unexpected developments in food prices or oil
prices could aggravate the underlying inflation
rate.

Such developments are much more likely to

add to price pressures than to relieve them.
If the worst happened on all fronts, we could see the inflation
rate in 1980 pushing up well above

8

percent.

This is not

our best-guess estimate, but we cannot rule out the possibility
of such a development.
Implications of a Heating Up of Inflation
Any significant acceleration of the underlying rate
of inflation will have adverse consequences on real economic
growth.

Financial markets will begin to tighten as a result

of increasing credit demands and expectations of rising interest




- 11 Jfates.

Housing starts would be adversely affected, and the

prospects for a strengthening of business investment would
also be reduced.

These tendencies would be accentuated by

efforts of the Federal Reserve to hold the growth of the
monetary aggregates within their target ranges.
past year, growth of Ml

Over the

(demand deposits and currency)

has been well above the Fed's long-run target range.
Fed would be unlikely

The

to permit continuation of monetary growth

overruns if the underlying rate of inflation began to rise
significantly.
The adverse effects on real growth of tightening financial
markets would be compounded by the effects of a rising
inflation rate on consumer and business confidence and spending
propensities.
and businesses

The personal saving rate would probably rise,
would begin to pull back from commitments to

long-term investment projects.

A growth recession —

with

real GNP still growing, but not fast enought to prevent a
rise in the unemployment rate —

would be a high probability.

If the worsening of inflation were severe, an actual downturn
in real GNP would be likely.
A substantial rise in the interest rates may get started
during the next few months, as economic activity rebounds from
the effects of the cold weather and the coal strike.




This early a

- 12 tightening of financial markets would produce its principal
effects on real GNP growth in the first half of 1979.

By

early 1980, an improvement in the rate of real growth could
be underway.
If tightening in financial markets began later, the
adverse effects on real growth could persist into 1980.
If the heating up of inflation and the resulting rise of
interest rates were severe, we could find ourselves in the
middle of a recession during the 1980 election campaign.
Even if this stark outcome is avoided —
a good chance that it can be —

and there is

a worsening of inflation will

clearly have serious consequences for the 1980 election.

The

American public is deeply concerned about inflation and what
the government is doing to deal with it.
Implications for Public Policy
The grim prospects that we face if inflation heats up
underscore the critical importance of following up
our anti-inflation program vigorously.

Unless we do so,

some acceleration in the rate of inflation as we move
toward a high-employment economy is a certainty.
The only questions are when the acceleration will occur and how
severe it will be.
The other major policy issue we must face squarely
is the need for changes in budgetary policy.

During

the first year of your Presidency, our economic strategy




gav e

higher priority to reducing unemployment than to

controlling inflation.

In light of the condition of the

economy when you took office, with the unemployment rate still
at nearly 8 percent, that emphasis was correct.

Since then,

however, we have made substantial progress in reducing
unemployment —

more than we expected —

reducing inflation.

but none at all in

The time has therefore come for a changed

emphasis in budgetary policy.
We do not believe that a major shift in fiscal policy
is called for.

Slamming on the fiscal brakes will not

solve the inflation problem, and it would produce disastrous
results.
of erring

But we must begin now to lean in the direction
on the side of too little, rather than too much,

fiscal stimulus.
In terms of the fiscal 1979 budget, we see no reason for
basic revisions of planned expenditures or of the magnitude of
net tax reduction .

But it is essential to keep the degree of

fiscal stimulus in 1979 from exceeding the amount planned.
You will have to be prepared to carry out your threat of a
veto of appropriations or tax bills that would enlarge the
deficit.

And if a shortfall in Federal expenditures develops

that permits budget outlays to fall below the $500 billion
mark, that shortfall should be welcomed as an opportunity to
reduce the deficit —

not as an opportunity for new initiatives,

or as a buffer that makes it unnecessary to resist Congressional
add-ons to the budget.




'

14
It is also extremely important, as you head into the
fiscal 1980 budget planning cycle, to guard against commit­
ments that have even the appearance of fiscal laxity.
example,

For

some time in the next month or so, you are scheduled

to announce your program of national health insurance.

If

that announcement implies large increases in Federal
budget expenditures in the next few fiscal years, your April 11
statement on the budget will no longer have any credibility.
Greater emphasis on fighting inflation must also
influence a variety of other decisions on economic policy.
For example, you cannot afford to back down on your expressed
willingness to veto any farm bill going beyond your recommenda\

tions, and you must strongly resist further extension of
protection to industries adversely affected by foreign trade.
If the Administration's intentions to give greater
emphasis to fighting inflation are to be effective, all of
your advisers must be made fully aware of your intentions, and
they must support them, publicly and privately.
succeed unless we have a united effort.




We will not

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