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W ASHINGTON

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January 7, 19
MEMORANDUM FOR THE PRESIDENT
From:

Charlie Schultze

Subject:

An Approach to Reducing Inflation

Your economic advisers have put together a program
aimed at getting a gradual reduction in the rate of
inflation over the next two years. The basic approach
was conceived by Barry Bosworth, the Executive Director
of COWPS. All of your economic advisers believe we
should pursue it. It will require a commitment of
Administration energy and time next year.
The attached memorandum is a brief outline of the
approach. We are sending it to George Meany, Doug Fraser,
Reg Jones, Irv Shapiro and John DeButts. After they read
it, we will meet with them (business and labor separately)
to get reactions and suggestions. Bosworth has discussed
it extensively with John Dunlop who thinks it is a workable
approach.
The Vice President, Stu Eizenstat, and I would like
to meet with you briefly on Monday to discuss its substance
and implications. I will try to get a time from Tim Kraft.
Welcome back!
Attachment




1/7/78

A Program for Reducing Inflation

The rate of inflation has stabilized over the last two
and one-half years within the range of 6-7 percent.
have been short-term deviations from this pattern.

There
But, they

have been due almost exclusively to volatile movements in
food and fuel prices, with no indication of any longer term
trending toward either higher or lower inflation rates.

A

similar pattern of a generally constant inflation rate is
evident on the wage side where 8-9 percent increases in
\

hourly compensation have become the norm.

With a standard

growth in productivity of about two percent —
near three percent rate of the 1960s —

down from the

these increases in

employment costs are consistent with the trend in prices and
constant profit margins.
There is nothing on the economic horizon to suggest that tkts
there will be any substantial departure from the current
trend.

For the present there are few reasons to expect an

acceleration of inflation.

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At the same time, however, the

opportunities for any additional slowing of price and wage
increases in an expanding recovery are painfully limited.
In the absence of specific government action, the most reason­
able expectation would be for inflation to continue in the
range of 6-7 percent over the next several years.

This

said, an important caveat must be kept constantly in mind:




- 2 -

this is that the risks of a higher future rate are greater than
the probabilities of moderation, since forecasts assume the
absence of any major shocks which unquestionably would add fuel
to the inflation.
It is true that we do not face the threat of a sudden explos­
ion of prices such as occurred in 1973-74.

Several events have

combined during the last two years to reduce the threat of a
sharp upward surge in the inflation rate from its current plateau.
Grain reserves have been replenished.

A current surplus of petrol­

eum and diplomatic negotiations have improved the outlook for
stability in energy prices.

Capacity shortages continue to be a

significant longer term threat, but the tax program will provide
incentives for adding to capacity and the acute near term prob­
lems are limited to a few industries.
But, we cannot point to similar positive developments which
would make possible a significant moderation downward of the
inflation rate from its current high plateau, or prevent a grad­
ual move to higher inflation rates as the economy approaches
higher levels of employment and capacity utilization.
It is abundantly clear that substantial deceleration will
not be forthcoming from any single major market.

Agricultural

prices have reversed the sharp rise of earlier years and any
further declines at the farm level will only create conditions
that will lead to major price increases in the future. Similarly,
raw material prices have receded from the high levels of 1974
and currently seem close to or below the costs of production.



- 3 -

A potential moderation of food price increases from the rapid
pace of 1977 will be more than offset in employer payroll
taxes and the higher minimum wage
If we are unable to slow inflation during a period in
which economic slack still remains, then we are almost cer­
tain to face higher inflation rates by 1980 or 1981 as the
economy approaches higher levels of employment and capacity
utilization.

Because of both public attitudes and economic

reality, an accelerating inflation would almost surelv bring
economic expansion to a halt, reverse progress towards lower
unemployment rates, and depress investment spending.
To combine an economic expansion with decelerating infla­
tion is a major challenge, particularly in the third and later
years of a business cycle recovery.
never been previously achieved.

Such a combination has

It is unlikely to happen

simply by letting events pursue their normal course.
If we are to make progress to moderate inflation it will
require strong efforts by both the government and the private
sector.
I•

The following is an outline of that effort.

^

Government contributions towards moderating inflation
The government will undertake a number of steps itself
0

incentives for capital formation to promote
growth of capacity and productivity

0

a responsible long-run budgetary policy

0

improved programs to deal with structural




unemployment

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- 4 -

0

substantially improved review, control and simpli­
fication of the government regulatory process

0

hospital cost containment

0

modest but positive steps to reduce costs and
prices directly/ by repeal of the telephone
excise tax and reduction of the Federal unemploy­
ment insurance tax rate

0

building farmer-owned reserves of grain against
future short supplies

0

the objective of deceleration in the rate of infla­
tion will be applied in the determination of fed­
eral pay increases in a fashion similar to that
suggested below for the private sector.

II. The private sector
The actions listed above will not alone be sufficient.
Slowing inflation while business activity expands will require
an effort to decelerate price and wage increases across a
broad front of individual markets.
The general characteristics of a deceleration program
and its rationale are outlined below.

Some of the qualifica­

tions to the general concept which would have to be recognized
in applying the principle to specific situations are discussed
and methods for consultation between the private sector and
the government are suggested.




- 5 -

A.

Rationale for a Deceleration Concept

There is a need to recognize that the inflation problem
cannot be quickly solved in a dramatic fashion.

It will be

necessary instead to demonstrate sustained, steady progress
toward achieving a lower rate over the next several years.
In addition, the momentum of the current inflation does not
result from unrestrained self-interest or the large price and
wage increases of a few.

Rather, it reflects the momentum of

general price and wage increases that are based on catching
up with pa^t inflation, keeping up with others, or on general
expectations of continued inflation at the current or higher
rate.
Thus, policy would focus on a deceleration of the overall

^

inflation rate with the explicit recognition that such overall
deceleration will have to result from deceleration in the vast
majority of individual markets.

It would begin with the initial 1

proposition that deceleration should and could be achieved in
every market. Individual industries should aim to achieve a
smaller price increase and individual wage increases should be
less than in prior years.

However, it is important to empha­

size that the amount of deceleration in wages and prices
that can be achieved may vary from situation to situation.

In

other words, we should not expect an equal amount of decelera­
tion in every labor market or industry because of different




- 6 -

circumstances that include such factors as profit margins,
labor productivity, import competition, and past wage perform­
ance.

Thus, the basic proposition would need to recognize

several qualifications:
Wages. A focus on deceleration of individual increases
is especially difficult on the wage side, because of wide
variations in past wage settlements.




Deceleration cannot be the same for all.

Those

who have received the largest increases in recent
years should decelerate more, and vice-versa.
There will also be very special cases where recent
gains have been so small as to permit no deceleration.
There should be a recognition of the need for vari­
ations in relative wa<jes from historical trends
in response to newly emerging tendencies (such as
skill changes, locational shifts, employment growth,
changes in productivity trends, the competitive
position of a specific industry, etc.).
Thus, individual situations will vary within an
overall pattern of deceleration.
Also, changes in work rules or practices that
significantly affect productivity would be recog­
nized as an integral part of any wage settlement.
The 1978 increases in employment taxes and the

- 7 -

minimum wage will add to employment costs.

The

deceleration of costs will have to be large enough
to offset these increases if any effective price
deceleration is to be achieved.
Prices. Similar qualifications will be required with
respect to prices:




Depressed price-cost margins relative to the his­
torical record will have to rise toward the average.
Certainly, there should be no criticism of firms
that lowered their price-cost margins during the
recession and are now restoring those margins as
demand strengthens.

However, the improvement in

profit-margins, as the expansion continues, should
come primarily from higher volume rather than in­
creased prices relative to standard costs.
Uncontrollable cost acceleration may result from
mandated programs (such as regulatory programs,
employment taxes increases, and minimum wage
changes), tax changes, or imported and other forms
of raw materials and some flexibility should apply
in those situations.

Prior labor contracts may

result in cost acceleration which is traceable to
decisions made prior to initiation of the decelera­
tion objectives.

- 8 -

Falling raw materials prices, increased produc­
tivity gains, or reduced second and third year
wage increases under multi-year contracts should
result in greater than average deceleration.
B.

Consultation with Individual Industries

The program would involve early discussions between the
government and individual industry and labor groups with
respect to specific areas which constitute a significant in­
flation problem.

On the price side, firms would be approached

separately" or, in those situations where legal problems can
be overcome, jointly as an industry group; they would be
requested to exchange information with CWPS about the outlook
for cost increases and market conditions.

These discussions

would involve cost projections and anticipated supply and
demand trends.

CWPS would work with staff assigned to the

project by the other agencies to develop a briefing paper on
the inflation outlook for that firm or industry.
The Chairman of C/TPS or other Council members would par­
ticipate in more extended discussions based upon the staff
review of the price-cost outlook and major problems of the
industry.

An effort would be made to assess the major sources

of price increases and to identify specific actions that the
parties could undertake to contribute to a moderation of
price and cost increases.




These discussions should be underway

- 9 -

by

February,

and in one or two cases where CWPS has been

following the industry on a regular basis, could begin inform­
ally in January.
Implicit criteria for selecting industries for such
discussions would include their importance to the economy,
the existence of discretion by individual firms in setting
prices and the occurrence of other major developments affect­
ing jobs, prices or costs.
The discussions of major wage negotiations should precede
the beginning of bargaining.

They would focus on a review of

past trends in relative wages, effects of the previous settle­
ment, productivity, and other conditions relevant to the environ­
ment of the negotiations.

These discussions would provide an

opportunity to emphasize the importance of deceleration, pos­
sible improvements in productivity and a review of potential
barriers to achieving deceleration.

3y scheduling such discus­

sion prior to the beginning of bargaining there would be no
conflict with normal bargaining procedures.
The deceleration concept has several advantages:




It recognizes that basic rates of price increases
must vary among markets because of differences in
productivity growth and material cost trends.
virtually all should be able to achieve some
deceleration.

Yet,




- 10 -

It provides an individual wage or price situation
with an understandable objective far in advance of
any specific decision.

For example, any discussions

with the government would take place before the
cost increases have occurred and while some discre­
tion with respect to prices still exists.

It focuses

on efforts to strengthen incentives to minimize
future cost increases.

It also avoids confronta­

tion over numerous individual price actions.
It provides a conceptual framework for government
actions that reduces the arbitrariness in the selec­
tion of specific sectors for focusing efforts to
reduce inflation.

In those markets where the absence

of price or wage discretion rules out discussions
with the private parties, it would provide a frame­
work for evaluating and coordinating a wide range of
government policies which affect prices and costs.
The establishment of a joint labor-management com­
mittee, conducted with the responsible government
department, may sometimes be a useful means to
explore opportunities for reducing costs and improv­
ing productivity performance.
Within this framework specific programs can be de­
veloped to reduce inflation in those markets (such

- 11 -

as food, housing and medical care) which are of
greatest concern to consumers.
C.

Elaboration of the Deceleration Scenario in the
CEA Annual ReDort

The CEA Annual Report would outline the inflation out­
look for 1978 within the confines of a deceleration scenario.
Among others, the following points should be stressed:




Some deceleration of retail food prices seems
achievable.
Moderation of energy price increases compared to
1976-77 is doubtful.
Service prices have increased at a particularly
rapid rate.

Some deceleration of the rate of

increase will occur with passage of the hospital
cost containment program, a slowing of local pro­
perty tax increases, and reduced excise taxes.
Commodities other than food and fuel typically
show a rate of price increase below the overall
inflation rate as a result of high productivity
growth.

But, while the rate of price increase is

below the average, it has shown a parallel amount
of acceleration compared to earlier periods of
lower inflation.

Thus, a similar amount of

deceleration will be sought in those markets.
Specific notice should be made of the slower growth

- 12 -

of productivity during the 1970s and its impact
on potential real income gains.
A slower rate of price increase will translate
into lower wage increases through the automatic
operation of cost-of-living escalators, but more
than a passive response will be required.
Given the persistence of a high and continuing rate of
inflation, the only strategy which holds promise for return­
ing to reasonable price stability is a gradual and pervasive
deceleration of wages and prices.

The principal benefits

of a deceleration strategy can best be appreciated over a
multi-year time frame.

In the absence of such a longer-term

strategy, there can only be a further institutionalizing of
the inflation momentum making eventual resolution even more
difficult and traumatic in its effect on the economy.

Gradual

deceleration supports expectations that price increases will
continue to slow, greatly increasing the likelihood that
successively lower rates of inflation will be factored into
wage and price decisions in future periods.

Taking into

account its favorable effect on sustaining economic expansion,
a successful deceleration effort will improve gains in out­
put, unemployment, and real income.




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