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March 30, 1 979 Mon ey and Prices - 1979 In a recent (March 2) WeeklyLetter,we discussed the results of statistical tests examining the relation between the money supply and inflation. These results supported approaches which explain most inflation in terms of money-supply growth. However, they failed to support cost-push theories, which say that the money supply usually increases in response to - or to accommodate - previous increases in wages or key commodity prices. The article closed by remarking that even though cost-push or accommodation factors were not found to be systematically important in explaining money growth and inflation, these factors still might be important in particular cases. In examining such special cases, a monetary approach wou Id use recent money-supply behavior to estimate the underlying rate of inflation. It would then look to non-monetary factors for sources of temporary - but sometimes important -differences between actual and underlying inflation rates. The present article uses such an approach to analyze the 1978 acceleration in inflation, and to suggest implications for the 1979 inflation outlook. Some features of our money price equation deserve mention. As suggested above, the equation relates the systematic or underlying part of inflation exclusively to lagged rates of growth in the money supply (with the brunt of the money supply's effect transmitted within ten quarters). However, the equation also allows random factors to temporari Iy alter the actual inflation rate away from its underlying value. Such "shocks" have both immediate and subsequent effects on inflation, reflecting the tendency for price changes to spread through the economy over time, and then eventually die out. Inflation in 1 978 Now, consider inflation developments in 1 978. Many commentators have pointed to increases in food prices, minimum wages, and payroll taxes (among other factors) as having served to accelerate inflation in 1978. Yet it's also true that money-supply growth started to accelerate in late 1 976 and early 1 977, and that this by itself would imply an acceleration in inflation in 1 978, given the lags in the effect of money on prices. If cost-push factors were predominant, there shou Id have been a consi.derable amount of 1 978 inflation that would not be explained by the money-supply terms in our equation. To determine whetherthis was the case, ourestimating equation can be used to "forecast" 1 978 inflation given actual M1 growth in the period. The "forecasted" inflation rate is then a measure of the amount of inflation attributable to . the money supply, while differe'ntes between actual and "forecasted" inflation presumably indicate the importance of non-monetary or random disturbances. Fou r quarterly "forecasts" of CPI inflation in 1 978 were thus obtained. For the year as a whole, the "forecast" price increase of 7.0 percent compared with an actual increase of 9.0 percent. (continued on page 2) 1 4 )il f I ,;I I;;ff \{ j ifl ttlf: \.:{t;=:vvs ()T U'1(0 Ff'ckTdl Re:o('iV(.' of trie Bankof SanFi-ancisco. nor orlhe Board These "forecasts" were made without the use of any 1 978 information except for actual money growth through 1 978.3. Yet the "forecasted" inflation rates were close to actual rates. Not only did the money supply account for an acceleration in inflation, but it gave quarterly inflation forecasts that were reasonably close to actual figures in every quarter but 1 978.2. To put these estimates in context, we may compare them to the forecasts made by major econometric modellers and economic analysts. At the beginning of 1 978, Wharton Econometrics forecasted 6.4 percent CPI inflation. Similarly, Time magazine's consensus rate was 6.2 percent, and Euromoney magazine's was 6.25 - 6.5 percent. These forecasts - which were made with full knowledge of the dollar's 1 977 devaluation, and of the coming increases in payroll taxes and the minimum wage - presumably included the profession's best guess as to the impact of these factors. However, they were much lower than actual experience, and also failed to perform as well as a "forecast" based on direct use of the money supply and actual 1 978 money growth figures. These points are not meant to criticize these forecasts, but to suggest that the money supply was at least as important - if not more important -than the dollar's 1 977 decline and legislated cost increases in explaining 1 978 inflation. Of course, one factor not generally known to forecasters at that time was the large increase in food prices that occurred in the first half of 1 978. These food-price increases may be integrated with the money-supply information to determine how much 1 978 can then be explained. In the long-run, the 2 r10flf)t food-price increase will not affect the price level, assuming no increase in the money supply to accommodate it, but will at most affect food prices relative to those of other goods. Still, in the short run, other prices. might be slow to react, and the foodprice increases could temporarily impact fully on the price level. In this case, we would expect the prices of other goods to rise at the underlying inflation rate, while food prices rise somewhat faster.The recorded inflation rate wou Id then be an average of these two different rates of increase. The underlying inflation rates implied by our equation are simply the "forecasted" inflation rates shown above. Using actual 1 978 consumer foodprice increases and money-supply growth rates, and a weight of 18 percent for food in the CPI, these calculations yield a yearly inflation rate "forecast" of 8.5 percent. In other words, the food-price phenomenon helps explain one-and-a-half percentage points of the difference between the actual and underlying moneyinduced inflation rates. Together, money-supply growth rates and food-price increases explain all but one-half of one percentage point of actual inflation. 1 979 Inflation What does this approach suggest about inflation in 1 979? The answer depends upon the assumptions we make about money-supply growth and food-price increases. First, we assume that the M1 money supplywill increase 6 percent in terms of historical rates. Given certain institutional changes, such as the impact of automatic-transfer accounts on the Percent 12 prices" 10 8 6 4 ,. " Money supply (M1) 2 1972 1974 * Increase over previous 1976 monetary aggregates, this is consistent with measured M1 growth of 1.5-4.5 percent. With this 1979 assumption and our actual 1978 money-growth experience, our simulation yields an 8.2 percent CPI inflation forecast for 1 979. This forecast measures the underlying rate of inflation due to monetary factors alone. We can use food-price factors to refine this forecast in several different ways. We might regard the food-price developments (reduced herds and bad weather) as a normal inflationary shock, which would have lingering effects on 1979 prices. These would add to monetary factors to yield a 1 979 inflation forecast of9.2 percent Alternatively, we might assume that these 1 978 problems served merely to hasten general inflation trends in food prices that would have occurred eventually anyway. In this case, with more normal conditions in 1979, the large food-price increases of 1978 would then be followed by smaller increases in 1979. The net effect on the price level by late 1979 mightthen be negligible. In this case, we would subtract the above-normal 1978 food-price increase from the underlying monetary forecast for 1979 to obtain an 1978 four quarters adjusted inflation forecast of 6.7 percent for 1979. Another scenario is presented by the Department of Agriculture's forecasted food-price increase - 8.5 percent - which suggests neither an improvement nor a worsening of the current situation. If relative food prices stabilized, and the price increases of other goods slowed somewhat to reflect increased expenditures on food, we might not experience any lagged inflationary effects of the earlier foodprice increase - but also might not experience any compensating slowdown in 1 979 inflation. Our initial 8.2-percent price forecast, based on assumed money-supply considerations alone, would then appear the most likeIyoutcome. In sum, based on different food-price scenarios, CPI inflation in 1979 should fall somewhE;re in the broad range of 6.7 to 9.2 percent, with an 8.2 percent value likely if the food situation turned neutral. But further strong increases in food prices, such as we have experienced in the fi rst two months of the year, could make higher values. more likely. Michael Bazdarich PublicationsAvailable Copies are now available of two recent speeches by John J. Balles, Presidentof the Federal Reserve Bank of San Francisco. "U. S. - Japan Economic Relations" outlines steps that should be taken by the two nations to stabilize the dollar and reduce barriers to world trade and finance. "Inflation - Causes and Prospects" discusses the role of monetary and fiscal policy in the current inflationary situation. Free copies of these and other ReserveBank publications can be obtained by calling or writing the Public Information Section, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 544-21 84. 3 uOlgU!4SEM • 4Eln • uogaJo • EpEAaN • o4EPI !lEMEH • ElUJoJ!IE:::> E U OZl J V· E>jsPIV 'llle:::>IO:JSpueJ:I ues C;S'"' 'ON GIVd : J9V lS Od 's'n llVW SSV1:::> @£1J(@<§@(QI JJ. BANKINGDATA-TWELFTHFEDERAL RESERVE DISTRICT (Dollar amounts in millions) SelectedAssetsandliabilities LargeCommercialBanks Loans(gross,adjusted)and investments* Loans(gross,adjusted) - total# Commercial and industrial Realestate Loansto individuals Securitiesloans U.s. Treasurysecurities* Other securities* Demand deposits - total# Demand deposits - adjusted Savingsdeposits - total Time deposits - total# Individuals, part. & corp. (LargenegotiableCD's) \M!eklyAverages of Daily Figures MemberBankReserve Position ExcessReserves(+ )/Deficiency (- ) Borrowings Net free reserves(+ )/Net borrowed(- ) . Amount Outstanding 3/14/79 Change from 3/7/79 121,560 99,205 28,976 35,590 20,508 1,573 7,744 14,611 40,193 29,516 29,622 50,413 40,958 18,124 \t\€ekended 3/14/79 + \t\€ekended 3/7/79 + NA NA Comparable year-agoperiod 7 82 75 39 16 56 + 1,620 + 1,649 + 1,059 + + + + 53 27 26 606 751 17 167 74 214 36 109 30 138 55 249 212 336 Changefrom year ago @ Dollar Percent FederalFunds- Sevenlarge Banks Net interbank transactions [Purchases(+ )/Sales(-)] Net, U.s. Securitiesdealer transactions [Loans(+ )/Borrowings (-)] 315 482 529 * Excludestradingaccountsecurities. # Includesitemsnotshownseparately. @ Historicaldataarenot strictlycomparable dueto changes in thereportingpanel;however,adjustments havebeenappliedto 1978datato removeasmuchaspossibletheeffectsof thechanges in coverage. In addition,for someitems,historicaldataarenotavailabledueto definitionalchanges. Editorialcommentsmaybeaddressed to theeditor(WilliamBurke)or to theauthor.... Freecopiesof thisandotherFederalReserve publicationscanbe obtainedbycallingor writingthe Public InfonnationSection,FederalReserveBankof SanFrancisco, P.O.Box7702,SanFrancisco 94120.Phone (415)544-2184,