Full text of Economic Commentary (Federal Reserve Bank of Cleveland) : Inflation and Soft Landing Prospects, July 1, 1989

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July I, 1989

sumer durable goods, such as furniture.
In general, the effect of interest rates
on consumer spending appears to have
gradually declined.

cause businesses to reduce their stocks
that, in tum, will contribute to a
weakening in aggregate demand by
midyear, according to one of the
Roundtable members.

Housing, however, is still sensitive to
interest-rate changes. Single-family
homes are especially sensitive to these
changes, which perhaps is best illus-

These comments do not imply that interest rates have no effect on spending.
Rather, the effects vary among the different sectors of the economy, and sen-

trated by the decline in sales and housing starts that occurred in response to
rising mortgage rates in 1987 and, of
course, to the stock-market crash in Oc-

sitivity of those sectors appears to have
lessened in recent years. It may be that
interest rates, and especially real rates
of interest, would have to rise to higher

tober of that year. However, that sensitivity apparently has lessened in
response to several financial market innovations and to regulatory changes af-

levels than they have been in order to
restrain spending.

finds no relationship for other con-

fecting mortgage markets, according to .
another Roundtable panelist.
With respect to interest-rate effects on investment spending, the point was made
that capital spending in 1989 would not
be curtailed by interest rates because the
rise in yields on long-term bonds has not
been large enough to affect capital
spending decisions. Moreover, interest
rates have probably peaked, according to
one economist, so that the direct effects
of interest rates on capital spending this
year would be negligible.
The runup in short-term interest rates
since early 1988, however, is expected
to curtail inventory investment. The

eCONOMIC
COMMeNTORY

Given that prospect, Roundtable participants discussed whether to expect
that monetary policy would shift
toward less restraint, or whether policymakers would risk a further reduction

Federal Reserve Bank of Cleveland

of the economy's growth rate in order
to avoid further price increases. Many
of the participants appeared to be willing to aim for a lower inflation rate
than the 4.5 percent indicated in their
median forecast.

Inflation and Soft Landing Prospects

by John J. Erceg

John J. Erceg is an assistant vice president
and economist at the Federal Reserve Bank
of Cleveland. The author would like to thank
Gerald H. Anderson and Mark S. Sniderman
for helpful comments.

• Conclusion
An important point discussed at the
Roundtable meeting is that the slowgrowth scenario of the consensus
forecast, even if it were achieved, is

The U.S. economy has been growing
steadily since late 1982 in what has become the longest peacetime expansion

The views stated herein are those of the
author and not necessarily those of the
Federal Reserve Bank of Cleveland or of the

on record.

Board of Go vernal's of the Federal Reserve
System.

The consensus forecast of a group of
economists who met recently at the
Federal Reserve Bank of Cleveland is
that the expansion will continue at least
through 1990, but at a pace slow enough
to prevent a further growth of inflation.

expected to accomplish little in terms
of bringing down the inflation rate
from the recent 5 percent zone, let
alone back to the 3.5% average annual
rate that existed between 1983 and
1987 (see chart 3). Therefore, if the
growth rate of the economy revives to,
or above, the growth rate of potential
output in the second half of 1990, as indicated in the consensus forecast, the
4.5 percent inflation rate that is now expected would become the base from
which the inflation rate in the early
1990s will build.

higher cost of holding inventories will

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

Address Correction Requested:
Please send corrected mailing label to
the above address.

Material may be reprinted provided that
the source is credited. Please send copies
of reprinted materials to the editor.

U.S. Postage Paid
Cleveland,OH
Permit No. 385

According to this view, real GNP will
increase at an average annual rate of 1.5
percent between 1989 second quarter
and 1990 second quarter, and then will
increase at about a 2.8 percent annual
rate in the second half of 1990 (see
table 1). Underlying this projected
slower growth rate is weakening
demand, especially for consumer
durable goods and residential construction, and a curtailed pace for exports
and investment spending, the two sectors that led the accelerated pace of

The economists met on June 2 at the
spring meeting of the Fourth Federal
Reserve District Economists' Roundtable. This Economic Commentary dis-

growth in the economy in 1987 and
1988. The consensus forecast points to
visible slowdowns in new car sales,
employment growth, and housing as in-

cusses their forecasts for the economy
and for inflation.

dications that output growth is slowing.

We should note before beginning our discussion that even if the consensus fore-

An alternative minority view among
Roundtable participants is that the
growth of the economy has slowed be-

cast of slower growth were achieved, the
inflation rate expected by the economists
by the end of 1990 will still be greater
than the average annual rate that

cause output has been constrained by
capacity limits in some parts of the
economy. According to this view, there
is sufficient strength of demand in most

prevailed between 1983 and 1987.

sectors of the economy, except for consumer spending and residential construction, to sustain growth of real
GNP that will grow at about a 2.5 per-

• Economic Prospects
A number of alternative views of
economic growth, each with somewhat
different implications for inflation, surfaced at the Roundtable meeting. The
median forecast of the 27 participants
indicates that they expect a "soft landing," that is, growth of the economy
will slow to a rate below its potential
output into mid-1990, and inflation
will rise a little less rapidly than its
nearly 5% annual rate since early 1988.

cent average annual rate at least
through the end of 1990. At the time of
the June 2 meeting, neither the rise in
interest rates nor the increases in the
foreign exchange value of the dollar
was thought to be strong enough to
slow the growth of demand. Consequently, Roundtable participants with
this view expect that upward pressures
on wages and prices will continue.

A consensus

forecast by 27

economists who met recently at the
Federal Reserve Bank of Cleveland
calls for continued slow growth in
output and a "soft landing" for the
economy through 1990. However,
their projected inflation rate is relatively intractable and prospects for
lower inflation in the near future do
not appear promising.

One Roundtable economist felt that a
2.5 percent growth rate for 1989-90 is
consistent with moderate inflation. According to his view, interest rates and
inflation have peaked. Primary sources
of sustained growth over the next
seven quarters will be capital spending
and exports. Capital spending is expected to increase 5 percent to 6 percent from 1988 because yields on longterm bonds have not moved up enough
to cause a cutback in capital spending.
He also believes that the U.S. trade
balance will continue to improve until
early 1990 when effects of dollar appreciation will slow or end the improvement. For the first time in this expansion, capital stock should increase
faster than nonfarm output and thus
relieve some of the upward pressures
on resource utilization and prices.
A few of the forecasters expect a recession that will be mild and that will last
two to three quarters, much like the
mild recessions in 1960-61 and 1969-70

CHART 1 MEDIAN FORECAST
Median Forecasts

Table 1

of Fourth District Roundtable:

Change in levels, billions of dollars, s.a.a.r.
1989

GNP in constant (1982) dollars
Personal consumption expenditures
Nonresidential fixed investment
Residential construction
Change in business inventories
Net exports
Government purchases
GNP in constant 1982 dollars

GNP and Related Items

Percent change,annual

IQa

IIQ

IIIQ

IVQ

IIQ

43.1
7.4

18.3

13.8

11.2

10.3

16.6

12.6

10.8

9.1

4.2
-1.2

2.1

-2.7

5.8
-1.6

-0.8

0.0

-5.5

-4.0

4.0
2.4

3.1
1.5

8.9

-12.9

17.6

2.9

-5.5
1.9

2.8

3.9

1.9

4.3

1.8

1.3

GNP implicit price deflator

3.9

Consumer Price Index

5.8

4.9
6.4

FRB index of industrial production

3.2

2.3

IVQ

20.8

25.8

31.0

13.0

13.5

15.2

16.6

0.1

3.9
1.7

3.0

4.2

2.0

-2.7
2.4

0.0

2.3
1.0

2.9

2.0

3.0

2.5
4.4

4.3

3.0

4.8

4.7

5.0
1.7

4.9
1.4

4.8
1.4

4.7

4.5

4.7

2.5

2.8

3.2

a. Actual data as of June 2, 1989 Roundtable meeting.
SOURCE:

Fourth District Economists'

Roundtable Meeting, Federal Reserve Bank of Cleveland, June 2,1989.;

rate

and U.S. Department of Commerce.

High

(see chart I). The recovery following

The discouraging and common element

As one Roundtable participant asked,

such a recession is expected to show
growth in output at about a 4 percent
annual rate. The brief and mild nature
of the expected recession will result in

of the soft-landing scenario is that the
inflation rate appears to be relatively in-

"Which is worse, 6 percent inflation or
a 6 percent unemployment rate?" If a
policy error were to be made, in which
direction should that error be made?

no large or lasting improvement in the
overall rate of inflation, according to
two of the recession forecasts.
•

Inflation Outlook

A soft landing implies that the inflation
rate of 5 percent or so will be constrained in response to a belowpotential growth rate in the economy.
Most of the Roundtable forecasters expect little relief in the inflation rate. The
median of their forecasts shows an increase in the GNP implicit price deflator at an annual rate in a 4.5 percent to
5.0 percent range from second quarter
1989 through third quarter 1990, after
which the inflation rate is expected to
ease insignificantly (see chart 2).
There is, however, considerable variance
around that median. The higher growth
path for output of 2.5% or more is linked
to further acceleration in prices largely
because of wage-cost pressures. The
zero to 1% growth path is linked to a
slightly lower inflation rate than anticipated in the median forecast.

A guest panelist at the Roundtable meeting made a number of points about inflation that raise some skepticism about the
feasibility of a soft-landing scenario. Inflation, he noted, builds momentum over
a long period and is difficult to bring
down quickly. In his view, it is necessary
to lower the nation's demand for goods
and services to just below the supply,
and to hold the growth rate of the
economy to 1%or so just to keep the inflation rate from rising further.
The stubborness of inflation that is anticipated in the Roundtable's median
forecast may reflect the fact that disinflation has typically been associated with
economic slack that is characteristic of
recessions. Because most of the softlanding scenarios are based on I percent
to 2 percent growth rates in output,
prospects for bringing down the inflation
rate do not appear to be very promising.
Implications for Federal Reserve
monetary policy in the present
economic setting are very uncertain.

Some of the group expressed a view
that policy risks must be taken to bring
down the inflation rate now; otherwise,
inflation will build and the cost of
bringing it down in the future will be

o~~---L~~~~~~--~----~--~~--~--~~
-1

tially in recent years to about 20 per-2~--~~~~------------------------------~
cent to 25 percent of total steel costs
IQa
IIQ
IIIQ
IVQ
IVQ
IQ
IIQ
IIIQ

1990

1989

CHART 2

MEDIAN FORECAST

OF GNP IMPLICIT

PRICE DEFLA TOR

Percent change, annual rate
7

5 -

High

- -LOa-

t-.

IIQ

IIIQ

IVQ

IIQ

CHART 3

GNP IMPLICIT

IIIQ

IVQ

1990

1989

would not opt for any further tightening that could result in a recession.

3 I-

5 I-

0
0

Actual
Forecast

1985

a. Actual data as of June 2, 1989 Roundtable
b. Based on fourth quarter to fourth quarter.
NOTE:

• Interest Rates and the Economy
Interest-rate-sensitive sectors of the
economy-especially
consumer
durable goods, housing, and business
investment-are
often monitored for
indications that aggregate demand is

Interest rates have had little effect on
consumer spending either currently or
earlier in this expansion, according to a

I-

1984

products. Hence, the cost-price pressures and the effect on overall inflation
may well be minimal, according to a
steel industry economist.

on business investment are mixed.

1983

production and its effects on steel
prices will be further constrained by
contracts with the large steel users and
by competition from imported steel

Roundtable discussants pointed out
that the major effect of higher interest
rates seems to be found largely in
single-family housing, although effects

r----

After taking into account some productivity improvement, the labor cost in
the agreement may add about I percent
annually to the total cost of steel

being affected by monetary policy.

PRICE DEFLATOR

Percent change, annual rateb
6

costs. They view the recent labor accord by some major steel producers as

and are still declining because of continuing productivity increases.

Roundtable participants believe that
the inflation rate may be peaking, and
although they believe no easing in
monetary policy is appropriate, they

• Wage-Cost Pressures?
Some Roundtable economists are concerned over prospects for accelerating
inflation because of a recent increase in
labor compensation and unit labor

acpush
imis

likely to be much smaller than the
publicized 20 percent increase in compensation over a 50-month period.
Labor costs have been reduced substan-

greater than it is now. They are willing
to accept the risk of a recession, and
cautioned against the kind of ease in
monetary policy that others in the
group expect will lead to a strengthening in output and to accelerating inflation after mid-1990. Still, a few

An alternative view expressed at the
meeting, however, is that the steel
cord does not suggest a wage-cost
for inflation. First, the settlement's
pact on the cost of steel production

tractable, despite the expected slow
growth in output.

gravate the inflation rate despite a widely expected slowing in the growth rate
of output.

IIIQ

2.0
Percent change at annual rates
1.1
1.0
2.0

examples of how cost pressures can ag-

7r-------------------------------------------~

1990

1989

OF REAL GNP

1986

1987

1988

1989

1990

meeting.

Lines represent averages of the three highest and the three lowest forecasts.

SOURCE:
Fourth District Economists' Roundtable
1989; and U.S. Department of Commerce.

Meeting, Federal Reserve Bank of Cleveland, June 2,

study by one of the panelists. His work
shows a weak relationship between interest rates and consumer spending in
recent years, unlike in the 1970s. He
finds little relationship between interest
rates and car sales, especially since
auto finance companies offer belowmarket interest rates to buyers, and

CHART 1 MEDIAN FORECAST
Median Forecasts

Table 1

of Fourth District Roundtable:

Change in levels, billions of dollars, s.a.a.r.
1989

GNP and Related Items

Percent change,annual

IQa

IIQ

IIIQ

IVQ

IIQ

43.1
7.4

18.3

13.8

11.2

10.3

16.6

12.6

10.8

9.1

4.2
-1.2

2.1

-2.7

5.8
-1.6

-0.8

0.0

-5.5

-4.0

4.0
2.4

3.1
1.5

8.9

-12.9

17.6

2.9

-5.5
1.9

2.8

3.9

1.9

4.3

1.8

1.3

GNP implicit price deflator

3.9

Consumer Price Index

5.8

4.9
6.4

FRB index of industrial production

3.2

2.3

IVQ

20.8

25.8

31.0

13.0

13.5

15.2

16.6

0.1

3.9
1.7

3.0

4.2

2.0

-2.7
2.4

0.0

2.3
1.0

2.9

2.0

3.0

2.5
4.4

4.3

3.0

4.8

4.7

5.0
1.7

4.9
1.4

4.8
1.4

4.7

4.5

4.7

2.5

2.8

3.2

a. Actual data as of June 2, 1989 Roundtable meeting.
SOURCE:

Fourth District Economists'

Roundtable Meeting, Federal Reserve Bank of Cleveland, June 2,1989.;

rate

and U.S. Department of Commerce.

High

(see chart I). The recovery following

The discouraging and common element

As one Roundtable participant asked,

such a recession is expected to show
growth in output at about a 4 percent
annual rate. The brief and mild nature
of the expected recession will result in

of the soft-landing scenario is that the
inflation rate appears to be relatively in-

"Which is worse, 6 percent inflation or
a 6 percent unemployment rate?" If a
policy error were to be made, in which
direction should that error be made?

no large or lasting improvement in the
overall rate of inflation, according to
two of the recession forecasts.
•

Inflation Outlook

Some of the group expressed a view
that policy risks must be taken to bring
down the inflation rate now; otherwise,
inflation will build and the cost of
bringing it down in the future will be

o~~---L~~~~~~--~----~--~~--~--~~
-1

tially in recent years to about 20 per-2~--~~~~------------------------------~
cent to 25 percent of total steel costs
IQa
IIQ
IIIQ
IVQ
IVQ
IQ
IIQ
IIIQ

1990

1989

CHART 2

MEDIAN FORECAST

OF GNP IMPLICIT

PRICE DEFLA TOR

Percent change, annual rate
7

5 -

High

- -LOa-

t-.

IIQ

IIIQ

IVQ

IIQ

CHART 3

GNP IMPLICIT

IIIQ

IVQ

1990

1989

would not opt for any further tightening that could result in a recession.

3 I-

5 I-

0
0

Actual
Forecast

1985

a. Actual data as of June 2, 1989 Roundtable
b. Based on fourth quarter to fourth quarter.
NOTE:

Interest rates have had little effect on
consumer spending either currently or
earlier in this expansion, according to a

I-

1984

products. Hence, the cost-price pressures and the effect on overall inflation
may well be minimal, according to a
steel industry economist.

on business investment are mixed.

1983

production and its effects on steel
prices will be further constrained by
contracts with the large steel users and
by competition from imported steel

Roundtable discussants pointed out
that the major effect of higher interest
rates seems to be found largely in
single-family housing, although effects

r----

After taking into account some productivity improvement, the labor cost in
the agreement may add about I percent
annually to the total cost of steel

being affected by monetary policy.

PRICE DEFLATOR

Percent change, annual rateb
6

costs. They view the recent labor accord by some major steel producers as

and are still declining because of continuing productivity increases.

Roundtable participants believe that
the inflation rate may be peaking, and
although they believe no easing in
monetary policy is appropriate, they

• Wage-Cost Pressures?
Some Roundtable economists are concerned over prospects for accelerating
inflation because of a recent increase in
labor compensation and unit labor

acpush
imis

likely to be much smaller than the
publicized 20 percent increase in compensation over a 50-month period.
Labor costs have been reduced substan-

An alternative view expressed at the
meeting, however, is that the steel
cord does not suggest a wage-cost
for inflation. First, the settlement's
pact on the cost of steel production

tractable, despite the expected slow
growth in output.

gravate the inflation rate despite a widely expected slowing in the growth rate
of output.

IIIQ

2.0
Percent change at annual rates
1.1
1.0
2.0

examples of how cost pressures can ag-

7r-------------------------------------------~

1990

1989

OF REAL GNP

1986

1987

1988

1989

1990

meeting.

Lines represent averages of the three highest and the three lowest forecasts.

SOURCE:
Fourth District Economists' Roundtable
1989; and U.S. Department of Commerce.

Meeting, Federal Reserve Bank of Cleveland, June 2,

July I, 1989

sumer durable goods, such as furniture.
In general, the effect of interest rates
on consumer spending appears to have
gradually declined.

cause businesses to reduce their stocks
that, in tum, will contribute to a
weakening in aggregate demand by
midyear, according to one of the
Roundtable members.

Housing, however, is still sensitive to
interest-rate changes. Single-family
homes are especially sensitive to these
changes, which perhaps is best illus-

These comments do not imply that interest rates have no effect on spending.
Rather, the effects vary among the different sectors of the economy, and sen-

trated by the decline in sales and housing starts that occurred in response to
rising mortgage rates in 1987 and, of
course, to the stock-market crash in Oc-

sitivity of those sectors appears to have
lessened in recent years. It may be that
interest rates, and especially real rates
of interest, would have to rise to higher

tober of that year. However, that sensitivity apparently has lessened in
response to several financial market innovations and to regulatory changes af-

levels than they have been in order to
restrain spending.

finds no relationship for other con-

eCONOMIC
COMMeNTORY

Given that prospect, Roundtable participants discussed whether to expect
that monetary policy would shift
toward less restraint, or whether policymakers would risk a further reduction

Federal Reserve Bank of Cleveland

Inflation and Soft Landing Prospects

by John J. Erceg

John J. Erceg is an assistant vice president
and economist at the Federal Reserve Bank
of Cleveland. The author would like to thank
Gerald H. Anderson and Mark S. Sniderman
for helpful comments.

• Conclusion
An important point discussed at the
Roundtable meeting is that the slowgrowth scenario of the consensus
forecast, even if it were achieved, is

The U.S. economy has been growing
steadily since late 1982 in what has become the longest peacetime expansion

The views stated herein are those of the
author and not necessarily those of the
Federal Reserve Bank of Cleveland or of the

on record.

Board of Go vernal's of the Federal Reserve
System.

higher cost of holding inventories will

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

Address Correction Requested:
Please send corrected mailing label to
the above address.

Material may be reprinted provided that
the source is credited. Please send copies
of reprinted materials to the editor.

U.S. Postage Paid
Cleveland,OH
Permit No. 385

The economists met on June 2 at the
spring meeting of the Fourth Federal
Reserve District Economists' Roundtable. This Economic Commentary dis-

growth in the economy in 1987 and
1988. The consensus forecast points to
visible slowdowns in new car sales,
employment growth, and housing as in-

cusses their forecasts for the economy
and for inflation.

dications that output growth is slowing.

We should note before beginning our discussion that even if the consensus fore-

An alternative minority view among
Roundtable participants is that the
growth of the economy has slowed be-

cast of slower growth were achieved, the
inflation rate expected by the economists
by the end of 1990 will still be greater
than the average annual rate that

cause output has been constrained by
capacity limits in some parts of the
economy. According to this view, there
is sufficient strength of demand in most

prevailed between 1983 and 1987.

sectors of the economy, except for consumer spending and residential construction, to sustain growth of real
GNP that will grow at about a 2.5 per-

A consensus

forecast by 27

Full text of Economic Commentary (Federal Reserve Bank of Cleveland) : Inflation and Soft Landing Prospects, July 1, 1989

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