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THE CHAIRMAN OF THE
C O UN C IL OF ECONOMIC A D V IS E R S
WASHINGTON

October 13, 1979

MEMORANDUM TO THE PRESIDENT
From:

Charlie Schultze

Subject:

An Outline of Short and Long-Run Anti-Inflation
Strategy

In recent weeks I have had a good reception for a
speech which (i) sets forth an analysis of the inflation
problem; and (ii) shows how the Administration's economic
policies are based on a short and long-term strategy for
dealing with that problem. I have compressed all of this
into a condensed set of notes that you might find useful
background material.

Attachment




THE PROBLEM
After two years of substantial and well-balanced growth, the
emergence of three closely linked problems in late 1978 and
1979 has threatened the economic health of the nation:
(i) accelerating inflation; (ii) surging energy prices;
(iii) a sharp slowdown in productivity growth.
The Nature of Today's Inflation
A.

Even during the 1974-75 recession, inflation was far from
eradicated: 6 to 6h percent underlying inflation remained.

B.

Recently, inflation (CPI) has sharply accelerated:
o 1977, 6% percent
o 1978, 9 percent
o 1979, 13 percent rate (continuing into recent months)

C.

Almost all of the acceleration can be traced to two major
factors:
o energy; the huge rise in energy prices added over
3 percentage points to the 1979 inflation rate, and
4 percentage points in recent months
o homeowner ship costs; added another 2 s percentage
*
points to the 1979 inflation rate.
(The CPI
substantially overstates the impact of housing
prices and mortgage interest rates on the cost-of-living.
In effect, it treats such costs as if all homeowners
had to renegotiate their mortgage principal and
interest payments upward each month in line with
rising home prices and interest rates.)

D.

Outside of these two areas (one real, one statistical)
the CPI has accelerated very little; the rise in the
inflation rate has been confined to a few sectors of the
economy

E.

Wage rate increases have also shown little acceleration in
1979.

F.

But, an additional problem has arisen from the sharp
decline in productivity growth. Even with wage moderation,
the rise in labor costs of production has accelerated
because productivity gains have slowed. Consequences not
yet fully reflected in consumer prices.

G.

Therefore, major sources of inflation acceleration are:




1.
2.

Energy
Homeownership costs (partly a statistical
illusion)
plus, a broader problem:
3. Slow productivity growth.

STRATEGY TO DEAL WITH INFLATION:
III.

SHORT AND LONG-RUN

Short run: Prevent temporary double-digit "bulge” in inflation
from spreading to rest of economy.
(a) it is absolutely essential to keep highly selective and
temporary double-digit inflation from generating a broad
based and permanent double-digit wage-price spiral.
(b) if we can keep this from happening in the immediate
future, then today's double-digit inflation will taper
off to single-digit inflation; (current 60 to 70 percent
annual rate increases in energy prices will moderate;
lower inflation rate and softening economy should bring
some relief on mortgage interest costs.)
But, even with a successful short-run policy, inflation won't
subside to the "old" 6J percent underlying rate when the
5
temporary "bulge" disappears. A new 8 to 9 percent underlying
rate is then likely to prevail. Why? The fall in productivity
growth to almost zero has raised the underlying rate of inflation.
\

o this is far too high an underlying rate
o moreover, any bad breaks in the future would
add a new inflationary impulse, not to 6h percent
but to an 8 or 9 percent rate;
Therefore
IV.

Long-Run Strategy has to aim at:
A.

Gradually reducing the 8 to 9 percent underlying rate

B.

Reducing our future vulnerability to bad breaks.
POLICIES:

V.

SHORT AND LONG-RUN

Short-Run Policies: Public and private restraint to keep
temporary bulge from becoming permanent double-digit wage-price
spiral.
A.

Budget




1.

Reduce growth of spending; lower the share of government
in GNP (also a key part of long-run strategy; see
below).

2.

Cautious fiscal policy; aim at budget balance as
rapidly as economy permits:
o careful not to apply premature or excessive
economic stimulus even in weakening economy
o doesn't mean "head-in-the-sand" aooroach to

B.

Monetary Policy
1.
2.

C.

Not Administration's direct responsibility
But combination of current restraint and cautious
but flexible attitude about applying stimulus
later, matches Administration's approach to fiscal
policy.

Voluntary wage-price guidelines (private restraint)
1.

Despite press reports, these have been remarkably
successful in keeping the temporary inflation
bulge from spreading: most price and wage
decisions have been moderate.

2.

Admittedly difficult to continue/ given this year's
history of 13 percent inflation.

3.

But recent "Accord," and establishment of Tripartite
Pay Committee bodes well for achieving that difficult
task.

Long-Run Policies: Designed to moderate underlying inflation
rate and to reduce vulnerability to outside shocks.
A.

Energy program. The program has several objectives.
But from anti-inflation standpoint the most important
is to reduce our dependence on imported oil and thereby
decrease our vulnerability to new inflationary shocks.
This objective is so critical that we are willing to
pay a short-run inflationary penalty now (decontrol),
to secure less vulnerability in the future.
(Spell
out major elements of program.)

B.

Long-Run Fiscal and Monetary Policies
1.

General principle: over the next three to four
years we will have to pursue more cautious and
restrained monetary and fiscal policies than would
normally be the case in a less inflationary era.

2.

This does not mean inflexible policies that ignore
development of recession tendencies. But for
the foreseeable future, monetary and fiscal
decisions will have to be approached with an
attitude of caution and more (but not exclusive)^
emphasis on restraint.

3.

We have to do this in order to provide a climate
in which the underlying rate of wage and price
increases (8 to 9 percent) can gradually be pulled
down.




Federal spending (Release resources for private use)
1.

Carter Administration has long-standing policy
of reducing spending/GNP ratio. This will free
up resources for private use.

2.

Over time these resources should go mainly to
investment, so as to raise the share of GNP used
for that purpose.
(Tax reduction of 1978 already
aimed in this direction.)

3.

This is the most important single thing we can do
to help improve productivity growth.

4.

(The timing and magnitude of any tax measures designed
to accomplish this purpose have to be decided in
context of fiscal prudence and caution, as outlined
above; i.e. not too early; not too much. But additional
resources for productivity-raising investment will be
forthcoming from Carter budget strategy.)

Regulatory reform (Increase competition and productivity)
1.

Economic regulations (air, trucking, rail, etc.):
deregulate

2.

Social regulations (environment, health, safety) :
we seek two objectives:
o proper balance between social gains and
economic costs in setting standards;
o more cost-effective ways of achieving whatever
standards are set.

3.

Regulatory reform initiatives help in inflation
fight chiefly by raising productivity (e.g. higher
load factors in airplanes, fewer truck backhauls;
lower costs and less disruptions in environmental
programs, etc.)

Grain reserves (reduce U.S. inflation vulnerability to
worldwide crop shortages, without use of trade-restricting
embargos)
1.

Wheat and feed grain reserves substantially built.

2.

Reserve program already has proven a success:




—

Soviet crop down drastically (225 to 180
million tons).

—

worldwide, 8% reduction in wheat and 3%
reduction in feed grain output

—

YQt, the resulting rise in grain prices has
been quite moderate, unlike 1972-73.

SUMMARY
VII.

We do have a comprehensive strategy and a set of short and
long-term policies to deal with inflation:
A.

Short-run
Objective:

Methods:

B.

isolate "temporary" inflation bulge and
keep it from generating long-term double­
digit wage-price spiral
fiscal and monetary restraint; wage-price
guidelines with new element of business and
labor participation

Long-run
Objectives:

Methods:

(Note:

(1) gradually unwind 8-9 percent underlying
inflation rate; and (2) reduce vulnerability
to outside shocks
Energy program (reduce vulnerability)
Grain reserve (reduce vulnerability)
Fiscal and monetary restraint (avoid
overheating, reduced pressure for
wage and price rises)
Reduce spending/GNP ratio (free resources
for productivity raising investment)
Regulatory reform (lower costs, raise
productivity, increase competition)

These long-run policies can and will be filled out, supplemented,
and expanded, as the 1981 and later budgets are formulated.
Depending on the specific economic circumstances we might,
for example;
o transfer more resources to private investment by
investment-oriented tax reductions needs as ADR
o cut costs by reducing scheduled social security
tax increases
o increase our investment in human resources through
improved youth trained programs,
o etc.
At this present time, of course, we cannot cite or discuss
such elements. But even without these, we can present the
overall "strategic" framework in which they will be considered.)




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