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October 3, 1 980

What's headfor Prices?
Most economists attribute inflation trends to
past changes in money growth, but "shocks"
of one type or another have also contributed
recently to the price upsurge. Last year's neardoubling of OPEC oil prices and this year's
drought-caused food shortages have created
bulges in the price indexes atop a high underlying rate of inflation. Any analysis of the
future direction of prices thus should consider the possibility of new shocks from such
factors, as well as the underlying productivity
and money-growth trends.

first-half upsurge
Vola.tility has marked price patterns in each of
the first several quarters of 1 980. In the first
quarter, the consumer price index (CPI)
soared at almost a 17-percent annual rate,
reflecting sharp increases in both energy and
homeownership components. During that
period, retail energy prices surged at a 53percent annual rate-more than double the
preceding quarter's pace-as the huge
crude-oil price increases posted by the OPEC
cartel in late 1 979 and early 1 980 filtered
through to the prices of energy purchased by
consumers. The homeownership component also rose at an accelerated pace,
under the influence of rising mortgageinterest rates. On the other hand, the increase
in retail food prices decelerated during this
period, reflecting declining producer prices
for livestock, fruit, vegetables, poultry and
eggs.

u.s.

The inflation rate-as measured bythe CPIimproved only modestly in the second quarter, as the index registered a 14-percent
annual rate of increase. Most of the improvement emanated from the energy component,
which rose at about the high fourth-quarter
rate rather than the stratospheric first-quarter
pace. The homeownership component again
increased sharply, but food prices continued
to rise moderately, in line with the first quarter's performance. Apparel and medical
prices also contributed to the slight secondquarter deceleration.

After the summer lull
The early-summer period was quite different,
with only a 5Y2-percent annual rate of CPI
increase overthe June-August period. Butthis
deceleration, marked by July's overall stability and August's single-digit inflation number,
turned out to be something of a fluke. The
major reason was a decline in mortgage rates,
which partly offset a sharp acceleration in
food prices. But the reported interest-rate declines of July and August actually represented
commitments made during the late-spring
downturn in interest rates. In view:ofthe midsummer turnaround in rates on new mortgage commitments, the housing component
wi II aggravate rather than cush ion the u pward movement in the overall index this fall.
Moreover, the recent upsurge in .food prices
may be just the beginning of a major rise in
that key component of the average household
budget. Over the June-August period, the
food component of the CPI rose at a 21 percent annual rate-more than three timesthe increase of the second quarter. That upsurge reflected drought-induced losses of
livestock and poultry, as well as even sharper
price increases for sugar, fruits and vegetables. More ominously, the CPl's future
movement wi II be affected by JuIy and August's explosive 62-percent annual increase
in producer prices of finished foods, and
equally huge food-price increases at the
crude and intermediate levels. The food component has a weight of nearly 18 percentin
the overall consumer-price index. Assuming
it rises at a 21 -percent annual rate over the
third quarter as a whole, the acceleration in
food prices between the second and third
quarters could add as much as two percentage poi nts to the rate of increase in the overa II
consumer price index.
Energy was an important contributor (along
with interest rates) to the recent price deceleration, but it poses a major question mark over
the near-term future. The energy component

and energy cou Id be expected to decelerate if
the recession continues, reflecting a low rate
of capacity utilization in manufacturing. Yet
during the fourth quarter, the consumerinflation rate appears likely to move into
double-digit territory again after the recent
softness, due to the present accelerated rate
of increase in food prices and homeownership costs. It may even approach the 1 4percent rate of the spring quarter.

of the CPI rose atonly a 3-percent annual rate
over the June-August period, compared with
a 33-percent rate of increase in the preceding
six-month period -reflecting a recessioncaused falloff in demand and consequently a
massive buildup of oil inventories throughout
the world. The Iran-Iraq conflict raises dark
cloud over the energy outlook, but no one yet
knows when (or if) the effects of that conflict
will outweigh the effects of a worldwide oil
glut.

a

After the recession
The energy situation requires a closer 1001<.
Some analysts believe the Middle East conflict will contribute to only a brief spurt in
energy prices, with the resumption of a moderate price pace later this year. They maintain
that spot prices for crude oi I and refi ned products will rise briefly, in such key markets as
Rotterdam, due to the initial fear of possible
shortages. That movement will provide support for the current structure of OPEC contract prices, including the recent $2-perbarrel increase posted by Saudi Arabia. But
spot prices should stabilize thereafter as basic
supply-demand factors come into play.

Many analysts, on the basis of past cyclical
productivity behavior, anticipate a weakening of price pn;ssures when the economy
moves into the recovery period. The CPI rose
at more than an 8V2-percent rate at the recession trough in the first quarter of 1 975, but
five quarters later it rose at only a 3 V2-percent
rate (see chart). A moderation of food and
energy prices accounted for some of that deceleration, but the remainder of the index
showed similar moderation, reflecting a
strong improvement in unit labor costs. In the
first quarter of 1976, private nonfarm output
per worker-hour rose at a 7-percent annual
rate, and compensation per hour at a 9percent rate. Consequently, unit labor costs
rose at only a 2-percent annual rate in that
period.

This analysis reflects the fact that worldwide
crude-oil inventories reached a monumental
6 billion barrels before the conflict. At that
level, it wou Id take a prolonged cutoff of the 4
million barrels/day of Iranian-Iraqi exports to
make a dent in the inventory. Moreover, that
impact could be mitigated by the decision of
other OPEC members to rescind a planned
la-percent production cutback decided
upon before the outbreak of the war.

Productivity growth may be slower in the
early stages of the forthcoming recovery than
it was during the 1 975-76 recovery period, in
view of the widespread expectation of slow
growth in business activity over the period
ahead. But if productivity growth reaches an
annual rate of (say) 3 percent, and compensation reaches a rate of (say) 1 0 percent, then
labor costs should rise at about a 7-percent
rate four quarters into the recovery period. A
movement of that type would cut the laborcost increase in half from the second-quarter
1 980 figure-but unfortunately, itwould also
represent a much higher increase than was
recorded in the early-recovery period of any
previous business cycle.

But this scenario is based on the assumption
that the Middle Eastconflict doesn't spread
beyond the Iranian-Iraqi borders. A far more
serious situation could arise if the Strait of
Hormuz were closed. More than one-third of
the non-Communist world's crude-oil supply
moves through that 24-mile-wide waterway.
During the fourth quarter, meanwhile, the
rate of increase in food prices should moderate somewhat as the effects of the drought
subside. Prices of all items other than food

That 7-percent projected rise in unit labor
costs cou Id represent a proxy fQr the underly2

ing rate of inflation in the 1981 economythe increase apart from food and energy
"shock" pressures on the price index. But
those shock effects could add several percentage points to the underlying trend next
year. Retail food prices could rise as much as
14 or 15 percent du ri ng 1981 -several
points above even the high 1 980 rate-as
suppl ies of Iivestock and food-and-feed crops
fall somewhat below year-earlier levels. The
energy situation remains a question mark,
depending upon whether the production and
export cutoffs resulting from the Middle East

confl ict seriously erode the heavy inventories
of crude ex isti ng throughout the world. If that
happens, the energy component of the CPI
could rise at a faster rate than in 1980. On
balance, despite major shock effects, the
overall price trend could improve in 1981
just as it did in the last business recovery. Still,
that would leave the inflation rate at a higher
level than it reached at the comparable stage
of any previous recovery.
Yvonne levy

Cyclical Behavior of Consumer Price Index
Percent
Change*
18

16
14

12
10
8
6

4
2
8

*Percent change from previous quarter at annual rate.

3

1 0 Quarters
Past peak

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8ANKING DATA-TWELFTHFEDERAL
RESERVE
DISTRICT
(Dollaramountsin millions)
Selected
Assets liabilities
and
LargeCommercial
Banks
Loans
(gross,
adjusted) investments*
and
Loans
(gross,
adjusted) total#
Commercial industrial
and
Realestate
Loans individuals
to
Securities
loans
U.s. Treasury
securities*
Othersecurities*
Demanddeposits total#
Demanddeposits adjusted
Savings
deposits total
Timedeposits total#
Individuals,
part.& corp.
(Large
negotiable
CD's)
WeeklyAverages
of Daily Figures
MemberBankReserve
Position
Excess
Reserves )/Deficiency
(+
(-)
Borrowings
Net freereserves )/Netborrowed( )
(+
-

Amount
Outstanding

Change
from

9/17/80

9/10/80

139,880
118,027
34,299
47,758
23,751
946
6,465
15,388
46,437
33,466
29,600
63,843
55,378
24,360

707
619
257
214
44
67
57
31
-1,738
51
61
238
148
242

Change
from
yearago
Dollar
Percent

-

-

-

Weekended

Weekended

9/17/80

9/10/80

19
166
186

21
136
156

-

5,556
6,862
2,291
7,019
487
1,271
1,164
142
1,870
2,984
753
9,543
9,433
4,022

4.1
6.2
7.2
17.2
2.1
- 57.3
- 15.3
0.9
4.2
9.8
2.5
17.6
20.5
19.8

Comparable
year-ago
period

-

62
226
164

* Excludes
tradingaccountsecurities.
# Includesitemsnotshownseparately.
Editorialcomments
maybe addressed theeditor (William Burke)or to the author....
to
copies this
of
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Reserve
publications beobtained callingor writing the PublicInformation
can
by
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Federal
Reserve
Bank-of Francisco, Box 7702, SanFrancisco
San
P.O.
941,20.Phone
(415) 544-2184.

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