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FRBSF

WEEKLY LETTER

December 14, 1984

Inflation: Retreating or, Reheating?
Actual inflation continues at a relatively low rate
compared to its double-digit pace of a few years
ago. Both the consumer price index and the price
index for total output-the GNP deflator, have
measured inflation in the neighborhood of four
percent over the last two years. Given that overthe
same period the unemployment rate fell more
than three percentage points and real output grew
more than ten percent, the failure of inflation to
rise is particularly noteworthy. In fact, many forecasters have been surprised by its continuing low
rate and have accordingly revised their inflation
forecasts downward for this year and next.
One signal that overall inflation may remain low
for the next few quarters is given by prices at the
wholesale level. Producer price changes often
foretell consumer price changes since cost increases at the wholesale level tend to get passed
onto the retail level. The inflation rate in producer
prices has been even lower than that in retail
prices. And recently it has fallen even further.
Producer prices have only risen three percent in
the two years since the current recovery began, in
contrast to their ten percent total rise in the first
two years of the 1975 -1980 recovery. From July to
October, producer prices actually fell. Few expect
deflation at the retai I level, but the low rates of
increase in producer prices have played a significant role in expectations of continued low inflation for the next few quarters.
The current relatively low rates of inflation are due
in part to transitory factors. These factors have depressed the observed, or actual, rate of inflation
below its underlying, longer term component
which is determined primarily by fundamentals
such as the basic direction of monetary policy and
the trend in labor productivity. This Letter discusses these temporary factors and the contributions
they have made to reducing both the observed and
the underlying rates of inflation and to keeping
current inflation low.
Importance of imports
Because expenditures for imported goods and services currently exceed $450 billion per yearabout one-eighth of GNP -changes in import
prices directly affect the overall domestic inflation

rate. They also exert indirect pressures that are
perhaps more important. Chart 1 shows the recent
inflation rates of the Consumer Price Index and of
a price index for imports. In 1979 and 1980, the
prices of imported goods rose much more rapidly
than other prices. The doubling of OPEC oil prices
was responsible for virtually all ofthis increase in
the relative price of imports. Since then, import
prices have risen very much less than other prices,
and for the last three years, have actually fallen.
The fall in import prices relative to the prices of
domestically produced goods'and services has
been due to the recent strength of the U.S. dollar in
relation to other major currencies. The tradeweighted real value of the dollar has risen about
40 percent since 1980. As a result, foreign suppliers have been able to charge lower dollar prices
while maintaining the profitability of their exports
to the United States. The lower dollar prices of
imported goods show up in the price indexes for
goods purchased by Americans, and thereby hold
down the overall rate of increase of those indexes.
Indirectly, the lower American price of imports
has led competing domestic producers to hold
down their prices. Almost everything we import
has a close counterpart, or substitute, produced in
the U.S. Autos, steel, petroleum, and clothing are
large domestic industries that must compete with
foreign producers of the same goods. Roughly half
of total domestic production consists of goods
with substitutes that are or could be imported. This
competition from foreign goods, whose dollar
prices have remained relatively low because of
the strong dollar, has kept a lid on both domestic
producers' and workers' ability to raise prices.
The price of one major imported commodity,
petroleum, is not directly affected by changes in
the value of the dollar because its price is set
primarily in dollars. But even the price of petroleum has fallen. Since the early 1980s, the dollar
price of a barrel of OPEC crude has fallen by about
one-third because the worldwide demand for oi I
has softened markedly compared to demand in
the late 1970s. Among the reasons for weaker oil
demand are the continuing increases in energy
efficiency and the very low real growth rates of the

FRBSF
world economy. The strong dollar also has helped
reduce the price of oil by making the cost of oil
higherfor countries other than the United States. It
thereby saps those countries' demand for oil and
puts downward pressure on oil prices.
The 14-percent increase in the real value of the
dollarovenhepasttwoquartersgivesusevery .
reason to expect inflation to remain quiescent
over the next year and perhaps to fall fu rther.
However, shou Id the real value of the dollar fall
significantly, short-term direct and indirect upward pressures on inflation, perfectly analogous to
those we experienced throughout much of the
decade of the 1970s, will re-emerge.

Once again, inflation and unemployment
Since labor costs constitute approximately three
fourths of costs for the economy as a whole,
changes in the growth rate of labor costs also play
a significant role in determining short-run changes
in the inflation rate of domestically produced
goods and services. How fast wages rise depends
on the amount of slack in the labor market. The
unemployment rate is a good signal of this slack
and, to a large degree, of the general level of
demand for domestically produced output. Its
level, then, is likely to be an important factor in
determining how fast wages rise.
Chart 2 plots the course over the last half dozen
years of the level of the unemployment rate and
the change in the growth rate of labor compensation per hour. During the late 1970s, the unemployment rate fell to relatively low levels and the
growth rate of compensation per hour rose. With
the higher unemployment rates of recent years,
labor costs have grown slower and slower. This
year, for example, compensation per hour is growing about half as fast as it grew during 1980. As
long as the amount of slack in labor markets remains substantial, such slowing is to be expected.
When the economy returns to more normal levels
of unemployment, this downward pressure on
wage and price inflation will disappear.

Deregulation and disinflation
The last few years have also seen some changes in
government budget and regulatory policies that

have helped reduce inflation in the short-run.
Compensation costs, for example, will not be
pushed up nearly as much by payroll tax hikes
between 1982 and 1985 as they were in the period
1978 through 1981, when payroll taxes increased
substantially. These increased costs apparently
were passed on by employers as price increases
that temporari Iy raisedtheinflation rate. Once this
pass-through was completed, the upward pressure on short-term inflation would have evaporated even without the help of other anti-inflation
government policies.
A similar temporary reduction in short-term pressure on inflation emanated from (de-)regulation
policy. The removal of a wide range of price regulations in the communications and transportation
industries prompted price declines in those sectors. These price decl ines fed back into downward
pressure on employee wages. Together, lower
costs and prices in deregulated industries helped
reduce the overall inflation rate temporarily. But,
again, once the adjustment is completed, the
underlying inflation rate will re-establish itself.

Summing up
The economy's underlying rate of inflation has
been reduced substantially in the past four years.
Overthattime, the actual rate of inflation has been
even lower than the underlying rate. The strengthening of the dollar, slack aggregate demand, and
adjustment to less price regulation have each
played a role in bringing down both the actual and
the underlying rate of inflation. However, the
actual rate will remain below the underlying rate
on Iy to the extentthat factors like these conti nue to
exert downward pressure. Once the dollar stabilizes and the adjustment to its level is complete,
and once the economy finishes its adjustment to
more normal levels of ur'lemployment and capacity utilization and to deregulation, actual inflation will move toward its underlying rate. As yet,
there are indications that these adjustments are
not complete. Until they are complete, the underlying rate itself may recede further. These forces
together may keep inflation relatively low for the
near future.

James A. Wilcox

Chart 1
Import Prices
Influence Domestic Inflation
(4·Quarter Growth Rates)
Percent

30

20

10

01----------\------_,..;;.-----

.10 '--_-'-_--'-_ _
1978 1979 1980 1981

'--_--'--_---L._~'_______J

1982

1983

1984

Chart 2
Higher Unemployment and
Slowing Growth in Labor Costs
Percent

11

I

10
I
I

9

I

I

",

'\
\

\
\

0.5
\

\

,
I

,,......__....

8

,
,

...

7

6

Percent
(4·Quarters)

Change in
Compensation Growth ~

\

o
\
\

Unemployment!
,
Rate
......."',J
.,

-0.5

-1

~~

5

1978

1979

1980 1981

1982

1983 1984

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.

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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)

Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments l 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U. S. Treasury and Agency Securities 2
Other Securities2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4
Total Non-Transaction Balances6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS

Two Week Averages
of Daily Figures

Amount
Outstanding

Change
from

Change from 12/28/83
Dollar
Percent?

11/28/84
186,775
168,039
51,621
61,371
31,030
5,075
11,631
7,105
189,069
42,805
28,892
12,200
134,064

11/21/84
- 376
- 319
157
38
180
1
58
0
-2,103
-1,842
219
198
63

10,750
12,684
5,658
2,472
4,379
12
876
1,058
1,928
6,432
- 2,439
575
5,079

6.6
8.8
13.3
4.5
17.8
0.2
7.5
- 14.0
1.0
- 14.1
8.4
4.8
4.2

40,007

344

410

1.1

40,427
21,902

261
-2,290

-

Penodended

Penodended

11/19/84

2,262
1,105

11/05/84

Reserve Position, All Reporting Banks
Excess Reserves (+ )/Deficiency (-)
Borrowings
Net free reserves (+ )/Net borrowed( -)

18
21
2

55
133
78

Includes loss reserves, unearned income, excludes interbank loans
Excludes trading account securities
Excludes U.S. government and depository institution deposits and cash items
ATS, NOW, Super NOW and savings accounts with telephone transfers
S Includes borrowing via FRB, TI&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
7 Annualized percent change

1
2
3
4

-

6.4
5.2

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