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February 10, 1978

Cost-Push
According to one view, the nation's
persistent inflation reflects the tendency for money growth at times to be
pushed above its target range by the
pressures generated by the financing
of large Federal deficits. Thus, the
prescription for reducing the inflation
rate involves gradual reductions in the
amount of deficit financing and in associated money growth. According to
another view, however, the various
rigidities present in the economy make
it difficult for a firmer monetary policy
to stabilize prices without also bringing
on a recession. Further, restrictive
policies would require a lengthy effort
with costly side effects in terms of lost
output. Estimatesprepared by the
Council of Economic Advisers suggest
that a gradual attack on inflation could
entail a six-years' delay in reducing the
jobless rate from 6 to 3 percent, at a
total loss to the economy of $600 billion. Thus, a constant search goes on
for other approaches which can curb
inflation at a smaller overall cost.
In the CEA'sview, the failure of wages
and prices to decelerate over the past
several years illustrates the strength of
the forces which support a basic 6- to
6 1 -percent inflation rate in the face
/2
of substantial slack in the economy.
The results can be seen in a smaller
and smaller deceleration of wages and
prices with each successive cyclical
contraction. Indeed, in the last cycle,
wages and prices rose sharply in the
year preceding the peak, but then rose
even more sharply in the late recession and early recovery period.
One major cause of inflexible wageprice behavior is the attempt by work-

ers to obtain constant increasesin real
wages, even where productivity gains
do not permit such increases.Again, a
widespread belief in continued inflation leads business firms to agree to
cost increases in the expectation that
they will be able to pass those increases forward in the form of higher
prices. In recent years, new rigidities
have developed in the form of government-mandated cost increases, such
as regulations designed to meet environmental, health and safety objectives.

Wagesand productivity
The persistence of wage inflation reflects continued high increases in unit
labor costs, which in turn reflect a con. tinued wide spread between compensation and productivity increases.
Hourly compensation increased 8.7
percent in 1977 - slightly below the
1976 figure - but productivity growth
slowed to 2.4 percent, as is typical in a
mature expansion. Productivity
growth generally is greatest in an earlyrecovery period - witness the 4.2percent growth of 1976 - because
overhead labor then becomes more
fully utilized while cyclically-sensitive
and high-productivity industries recover faster than the rest of the
economy.
Serious problems have been caused by
a slowdown in productivity growth
over the past decade and a half, compared to the first half of the postWorld War \I period. This long-term
productivity slowdown reflects the
virtual end of the massive shift of farm
workers to more productive non-farm
pursuits. The slowdown also reflects
(continued on page 2)

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Opinions expressed in this newsletter do not
necessarily reflect the views of the management of the
Federal Reserve Bank of San Francisco, nor of the Board
of Governors of the Federal Reserve System.

the gradual adjustment of the economy to higher energy prices, as more
costly resources are substituted for
previously cheap energy inputs. A
slower relative growth in the nation's
capital stock is an important factor, as
is also (to a lesser extent) the rise in the
proportion of inexperienced women
and younger workers in the economy.
Environmental regulations are also important, as seen in increased limitations on choices of raw materials and
plant sites, delays in construction, and
constraints on production processes.
Increases in sales and payroll taxes are
an extra cost consideration, as is also
the continued rise in minimum wages.
Cost and price pressures should intensify as the labor force becomes more
fully employed. The unemployment
rate, although declining sharply in recent months to 6.3 percent in January
1978, is still considered to reflect a
substantial amount of slack in the economy. However, that rate would be
close to 5 percent if today's labor force
had the same demographic make-up
as the labor force of two decades ago.
Stronger labor-market pressures are
also indicated by the sharp rise in the
index of help-wanted advertising, and
by the rise in total employment to a
record 58 percent of the total population.

CPt influence
Negotiated wage increases,are heavily
influenced by movements in the consumer-price index, which affects both
the size of cost-of-living allowances
and other elements in the wage pack-

2

age. The rate of increase in consumer
prices moderated over the 1975-76
period, but then worsened again in
1977.These ,fluctuations were related
principally to erratic variations in food
and energy prices. But prices of other
categories, which account for twothirds of the total market basket, rose
at almost the same 6 to 6 V2-percent
rate in each year of this recovery
period.
The rise in food prices is likely to be
considerably smaller in 1978 than in
1977,because of improved supplies of
grain, pork, fruits and vegetablesbut not beef. Also with OPEC prices
stabilized, consumers' energy prices
should continue to reflect the gradual
adjustment of domestic prices to
world levels. But other cost and price
pressures are evident - from the decline in the value of the dollar, from the
projected first stage of the crude-oil
equalization tax, and from several government actions (e.g., a $6-billion rise
in employer payroll taxes and a 15percent rise in the minimum wage).
I

VVages,
fringes,
taxes
Employer costs have increased not
only because of steady increases in
wages and salaries, but also because
of even-sharper increases in wage supplements -largely employer contributions for social insurance and private
pension funds. These fringe benefits
increased from less than 8 percent of
the total wage package in 1960 to 17
percent of the total in 1977.Their magnitude will rise substantially in the next
several years because of sharp in-

P ROD U CTI VI TY,

CO STS AN D P RI CE S

% Change

12
8

Unit labor costs);"
Compensation

per hour

4

creases in social-security taxes. Total
(employer plus employee) contributions to social insurance funds will rise
50 percent between fiscal 1976 and fiscal 1979, to $151 billion.
In reviewing a number of proposals for
reducing cost pressures through reductions in taxes - e.g., state sales taxes and Federal unemploymentinsurance and social-security taxesthe CEA has found that reductions in
one area will only mean higher taxes in
other areas. As a better means of controlling cost-push factors, it has suggested a set of guidelines (left
unquantified) which employer and employee groups would voluntarily follow in their future wage and price
decisions. Otherwise, it sees little
hope of bringing about the necessary
deceleration in the wage-price spira\.

Investment and profits
The inflation problem could worsen if
insufficient capacity is available when
the economy approaches full utilization of resources. Thus, increased investment is a necessity, but this might
be difficult to achieve if corporate
profits are inadequate to the purpose.
However, the adequacy of profits is
difficult to measure because of inflation itself - and the tendency of many
people to ignore the necessary costs
of replacing inventories and capital
goods at today's prices. Whereas total
pre-tax profits equalled roughly $172
billion in 1977, adjusted profits
amounted to only about $140 billion,
after taking account of this inflation
impact on the value of inventories,

3

plant and equipment. Inflation thus
boosted the effective tax rate, because
taxes were levied on total profits before those adjustments.
for this and other reasons, business
fixed investment (in real terms) has
grown very slowly in recent years. In
the final quarter of 1977, it was still 2
percent below the level of the preceding cyclical peak, whereas it would
have been 14 percent above that figureif this expansion had conformed to
the pattern of earlier expansions.
Equipment investment recently has
been in line with historical trends, but
the investment in structures has lagged
considerably below trend. The appar.ent reason is a rise in the perceived risk
of investment in the 1970's, because
of higher (and more variable) inflation,
wider cyclical fluctuations in output,
and the uncertainty resulting from
higher energy, foreign-exchange and
environmental costs.
A stable financia! environment and investment-enhancing tax measures apparently are needed to stimulate
growth in the nation's capital stock. To
accomplish the latter purpose, the Administration has proposed a reduction
in the corporate tax rate and a liberalization of the investment-tax credit, especially the extension of that credit to
structures. But to accomplish the former purpose, a continued attack on
inflation through traditional monetary
and fiscal measures also seems necessary - since, in the long run, inflation is
primarily a monetary phenomenon.
William Burke

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BANKiNG DATA-TWELF TH fEDERAl!..
RESERVE STRI
DI
CT
(Dollaramounts millions)
in
Selected Assets and liabilities
large Commercial Banks

Amount
Outstanding
1125178

Loans
(gross,
adjusted) investments*
and
Loans
(gross,
adjusted) total
Security
loans
Commercial industrial
and
Realestate
Consumer
instalment
U.s. Treasury
securities
Other securities
Deposits
(less
cashitems) total*
Demand
deposits
(adjusted)
U.s. Government
deposits
Timedeposits total*
States politicalsubdivisions
and
Savings
deposits
Other time depositst
Large
negotiable
CD's

105,920
84,000
3,043
24,967
27,750
14,820
7,541
14,379
102,688
28,693
345
72,043
6,669
31,486
31,402
13,334

Weekly Averages
of Daily Figures

Week ended
1/25178

MemberBankReserve Position
Excess
Reserves()/Deficiency
+
(-)
Borrowings
Net free( )/Net borrowed(-)
+
federal Funds-Seven large Banks

+
+

13
12
1

Change
from
1/18/78
+ 1,213
+ 1,221
+ 1,115

-

201
109
47
- 30
22
+
- 1,206
- 903
- 215
162
- 23
- 57
- 19
197

+
+

-

Change
from
yearago
Dollar
Percent
+
+
+
+
+
+

-

+
+
+

-

13,772 + 14.95
14,206 + 20.35
1,770 . + 119.04
2,238 + 9.85
5,958
+ 27.34
2,550
+ 20.78
1,855 - 19.74
1,421
+ 10.97
10,814 + 11.77
2,996
+ 11.66
4:4 - 11.31
7,503
+ 11.63
733
+ 12.35
581
+ 1.88
5,752
+ 22.42
3,902
+ 41.37

+
+
+
+
+
Weekended
1/18/78
+
+

15
4
11

Interbank
Federal
fund transactions
Net purchases
(+)/Net sales(-)
+ 1,546
+ 694
Transactions u.s. ecurity
with
s
dealers
Net loans(+)/Net borrowings
(-)
+ 765
+ 426
*Includes
itemsnot shownseparately.
tlndividuals,
partnerships corporations.
and

Comparable
year-ago
period
+
+

64
8
56

+ 688
+ 188

Editorial comments may be addressed to the editor (William Burke) or to the author ••••
Information on this and other publications can be obtained by calling or writing the Public Information
Section, Federal Reserve
Bank of Sanfrancisco, P.O. Box 7702,SanFrancisco 94120.Phone (415) 544-2184.