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October 24,1981

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H ow FastCould Inflation Be-Eliminated?
The inflation rate, measured by the GN P
deflator, decelerated from a 10.7 -percent
annual rate in the fourth quarter of 1980 to a
6.6-percent rate in the second quarter of
1981. How long would it take, with a
non-inflationary monetary policy, to
eliminate inflation altogether? Simulation
results based on a small econometric model
of the U.S. economy the author has
developed in recent years suggest that the
task could be accomplished essentially
within two years' time, and completely
within four years' time. But the task could be
complicated by shifts that take place in
inflation expectations-and most probably
would be accompanied by a recession.

Episodes of slowing inflation
Two major decelerations in inflation have
occurred during the past 30 years. In the most
recent case, the inflation rate dropped from
1.1.3 percent to 10.2 percent between the
fourth quarter of 1974 and the first quarter of
1975, and then fell gradually to a low of 3.6
percent in the first half of 1976 (see chart).
The inflation rate thus fell by more than half in
a year and a half, and might have fallen even
further if fiscal and monetary policymakers
had not adopted new stimulative measures in
1977. Special circumstances, such as the
Arab oil embargo and other supply factors,
also temporarily affected the inflation rate
during this episode.
Tlie other major geceleration followed the
1 2-percent Korean War inflation peak in the
first quarter of 1951. After U.S. military forces
became involved in that action, consumers
bought everything in sight in anticipation of
World War II-type shortages. But businesses
soon restocked their depleted inventories,
and the government increased taxes and
imposed credit controls to hold demand
growth to a non-inflationary rate. As a result,
inflation was eliminated almost immediately.
Historically, in several foreign countries,
governments have brought hyperinflations to

a screeching halt by instituting reforms that
succeeded in strictly limiting government
budget deficits and paper-money issuance.

Inflationary expectations
The speed of reducing inflation depends on
the speed of adjustment of inflation
expectations. In 1975-76, high inflationary
expectations were built into the system. The
public was understandably dubious after
years of observing anti-inflation rhetoric
coupled with the actuality of accelerating
inflation. Consequently the adjustment was
slow and costly. In 1952, in contrast, inflation
expectations weren't built in. People
expected that wartime inflation would be
followed by deflation as they had observed
previously. Hence, once they had refilled
their larders in 1952, they didn't expect more
inflation; and the price adjustment came to
an end. The record is clear. If the public
accepts anti-inflationary policies on faith,
inflationary expectations and the inflation
rate adjust rapidly. On the contrary, if a lot of
Doubting Thomases have to see inflation fall
to believe it, the adjustment is slow and costly
in terms of unemployment and recession.
Sustainable inflation
To understand the role of expectations, we
should consider the sustainable
inflation
rate-the rate that would be sustained if
actual and expected inflation were the same.
Actual inflation (P) by definition equals total
GN P growth in dollar terms (Y) le2.Sreal G N P
growth (X). Sustainable inflation (P) by
definition thus equals
growth less
sustainable real growth (X).
We hypothesize that the public forms
inflationary expectations on the basis of
certain identifiable factors influencing
spending growth and sustainable real growth.
Since the latter is strictly limited by the
availability of productive factors, inflation is
largely a consequence of too much spending.
Though the annual real-growth rate fell a fu II

Opinions expressed in this newsletter do not
necessarilv refleel the
(}f
the rnanagemenl
of the Federal Reserve Bank of San francIsco,
nr of the Board of Covernors of the Federal
Reserve Svslern.
percentage point in the 1970's, the inflation
rate increased to 10 percent as a
consequence of rising spending growth.
Nevertheless changes in real growth have
sometimes caused inflation. The Plague
killed a third of the European population in
the 1 4th Century and caused a decline in
output and a substantial rise in prices. That
case would not by typical, however. In the
1970's, the observed one-percentage-point
reduction in average real growth represented
all the supply-side factors contributing to
inflation: drought, pestilence, oil cartels, tax
rates, environmental-protection regu lations,
labor and business monopolies, labor-force
composition, etc.

In the framework of our table, sustainable
inflation represents the inflation rate that
would persist on the basis of the underlying
inflation determinants other than the cyclical
effects of demand pressure. And as the chart
shows, inflationary pressure existed
whenever sustainable inflation exceeded
actual inflation. Persistent inflationary
pressure was associated with accelerating
actual·inflation (for example, 1 961 -66 and
1 971 -75), whereas negative inflation
pressure. was associated with decelerating
inflation (for example, 1 956-58 and
1 975-76). These effects were not always
immediate. Despite negative inflationary
pressure, inflation increased for a full year in
1 956-57 before turning down. Also, because
of wage-price controls, inflationary pressure
existed alongside stable or falling actual'
inflation in 1 971 -72 -but the inflation lid
blew off when the controls expi red
in 1 973-74.

Factors influencing spending growth
In our model, monetary growth and trend
spending growth together accounted for 6.9
percentage points of the 7.2-percent average
spending growth of the 1 953-80 period.
High-em p Ioyment govern ment spend i ng had
a significant impact, although it washed out
ina I ittle over a year, and exports had a small
residual effect on total spending. Though
only half the variation in spending growth
could be explained statistically, monetary
growth was the most important identifiable
factor with a systematic effect on spending
growth -and thus on inflation.

Despite innumerable special factorswage-price controls, strikes, crop failures, oil
embargoes, and the like-a systematic and
significant relationship existed over the
1 953-80 period between monetary growth
and spending growth, and in turn between
spending growth and inflation. Our research
illustrates that association, and shows the
timing of adjustment of actual inflation to
sustainable inflation. The estimated
adjustment reflects the time required for the
economy to ad just expectations and prices to
the underlying factors systematically
associated with inflation.

Over the 1 953-80 period, spending
increased 7.2 percent annually which in itself
would sustain a like rate of inflation.
High-employment real growth increased 3.3
percent annually, which would reduce
inflation by a like amount. Together, spending
and real growth thus explained nearly all of
the 4.1 -percent average inflation rate (see
table). The small residual is accountable to
two factors. (1) Rising import prices had
important supply effects in 1 974-75 and
again in 1 980, but on the average contributed
only 0.1 percentage points to average
inflation. (2) Demand pressure-the gap
between the levels of total demand and
supply-varied
in both directions over the
business cycle, but on the average also
contributed only 0.1 percentage points
to inflation.

What would happen now if monetary growth
were reduced enough to eliminate inflation
permanently? According to the author's
model it would be necessary to hold M 1B
growth at an annual rate of zero to 3 percent,
.which is about the range of M1 B growth in
recent months. The adjustment would not be
instantaneous, requiring four years
altogether. But the inflation rate could be
reduced by more than half in one year, and by
nearly four-fifths in two years. In other words,
the inflation rate would be 2 percent or less
two years' time-in
contrast to the
2

duration-similar to those experienced by
the U.S. economy in earlier periods of
decelerating inflation. Thatthe U.s. economy
has survived the anti-inflationary
decompression chamber before is somewhat
reassuring. That it might again require a
disquieting case.of the recession bends is
not a cheerful prospect- but then, neither
is inflation.
William G. Dewald

7.3-percent figure forecast by the
Administration for 1982.
In our analysis, we have simply evaluated
how soon inflation could be eliminated if the
authorities set monetary growth at a
noninflationary rate and left it there. We
found that, with the same response as in the
past, inflation could be cut in half in one year
and eradicated in four years. However, the
cost could be a recession of about a year's

Underlying Causes of Inflation
(1 953-1980)
Average

(Percent)
1
4.3
7.69
10.56

Trend Spending Growth
M 1-B Monetary Growth
High Employment Government Spending Growth
Growth

Estimated
Weight

2.426
1.039
-0.003
0.024

Contribution
to Average
Inflation
(Percent)
2.4
4.5
0.0
0.3

Spending Growth

7.24

1.000

7.2

High Employment Output Growth
Price Inflation

3.33
4.74

-1 .000
0.027

-3.3
.1

High Employment Output Growth Adjusted for Import
Price deflation

-3.2

Demand Pressure (Level)*

1.59

Inflation

0.034

.1
4.1

* Demand

pressure is defined as the difference between the level of estimated real demand and
high employment output, both in logarithms. The level and growth rate of high employment output
were adjusted to incorporate effects of factors estimated to offset inflation autonomously such as
import prices. About four-fifths of the variation in inflation was accountable to these underlying
factors.

Inflation

pressure ....

1960

1965

2

o

1955

3

1970

1975

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RANKINGDATA-TWELFTHFEDERAL
RESERVE
DISTRICT
(Dollaramountsin millions)
SelectedAssetsandLiabilities
LargeCommercialBanks
Loans(gross,adjusted)
andinvestments*
Loans(gross,adjusted)
- total#
Commercialand.industrial
Realestate
Loansto individuals
Securities
loans
U.s.Treasury
securities*
Othersecurities*
Demanddeposits- total#
Demanddeposits- adjusted
Savingsdeposits- total
Timedeposits- total#
Individuals,part.& corp.
(Largenegotiable
CD's)
WeeklyAverages
of Daily Figures
MemberBankReserve
Position
Excess
Reserves
(+ )/Deficiency(- )
Borrowings
Netfreereserves
(+ )/Net borrowed(
-)

Amount
Outstanding

Change
from

10/7/81
153,707
132,725
40,275
54,655
23,136
1,787
5,682
15,300
42,028
29,194
29,774
86,201
78,287
34,204

9/30/81
413
330
44
80
75
255
9
74
- 349
564
248
1,001
995
346

C::hangefrom
yearago
Dollar
Percent
11,648
12,640
5,273
6,007
830
802
824
1.64
4,370
5,045
232
21,107
21,844
9,734

Weekended

Weekended

10/7/81

9/30/81

85
3
82

222
99
123

8.2
10.5
15.1
12.3
3.5
81.4
- 12.7
1.1
9.4
14.7
0.8
32.4
38.7
39.8

Comparable
year-agoperiod
90
38
52

* Excludes
tradingaccountsecurities.
# Includesitemsnotshownseparately.
Editorialcommentsmaybeaddressed
to theeditor(WilliamBurke)or to theauthor. ... Freecopiesof this
andotherFederalReserve
publications
canbeobtainedbycallingor writingthePublicInfonnationSection;
FederalReserve
Bank of SanFrancisCo,
P.O.Box7702,SanFrancisco94.120.
Phone(415)544-2184.