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LIVING WITH INFLATION An Address to the Economics fo r Executives Forum Georgia C ollege M ille d g e v ille , Georgia September 19, 1974 by Monroe Kimbrel, President Federal Reserve Bank o f Atlanta LIVING WITH INFLATION You heard that the title of my talk is "Living with Inflation." But before I get into that topic, I want to say just a few words about the broader economic climate in which we find ourselves today. People in Washington and elsewhere are still debating whether we are in a recession. Those who say, "Yes," allude to back-to-back declines in GNP adjusted for price changes; those who say we are not in a recession feel the declines are too small to be significant. As important as that question is, I believe the more important ques tion is whether the economy will slide off further, head upward, or just keep rocking along on a plateau. From what I can tell, the economy is more or less holding its own, and there is little evidence that anything will replace this economic sluggishness very soon. Many people are concerned about the economy's performance, and r ig h tly so. But the p u b lic 's main economic concern, according to a Gallup p o ll, is s t i l l in f la t io n . I t was not too many years ago when some o f us shuddered when we heard mention that a 1- or 2-percent r is e in p rice s was in e v ita b le and harmless to b o o t. Contrast th is with la s t y e a r 's 9-percent increase in consumer p rice s in th is country, the worst in fla t io n sin ce 1951. P a rticu la rly d is tre s s in g is that p rice s keep clim bing at an alarming ra te . The in fla t io n rate h it a d o u b le -d ig it 14-percent fig u re in th is y e a r 's f i r s t quarter and was s t i l l a thumping 9 percent in the second One. What some o f us have long suspected has become abundantly c le a r : No matter how much we f r e t , the problem o f in fla t io n simply is not going away. I fin d several aspects about th is problem e s p e c ia lly d istu rb in g . It used to be that prices would rise rapidly only after wars. But we cannot -2- say that any more. h a lf ago. The tra g ic war in Southeast Asia ended a year and a Our country is at comparative peace; y et in fla t io n remains rampant. For y ea rs, we used to say: "Sure, we have in fla t io n but look how much m ilder ours is compared to the re s t o f the w o r ld ." But now we cannot take com fort in the thought we are not as bad o f f as everybody e ls e . The i n f l a tio n in th is country is as serious, or almost as se rio u s, as that o f most major in d u s tria l co u n trie s. This change is important, not ju s t fo r our own sake but, because i f i t contin ues, fo re ig n e rs w il l buy less American products. That would hurt our economy as w e ll as our balance of payments. The g a llop in g p rice trend in th is country has i t s seeds in the Vietnam War, when we t r ie d to have guns without givin g up b u tte r. Before the Vietnam buildup, th is country a ctu a lly enjoyed a period o f p rice s t a b ilit y that many o f us have fo rg o tte n . For s ix y ea rs--from 1958 to 1964--the Consumer P rice Index rose only 1 percent per year. Vietnam. Then came our involvement in The Government stepped up it s spending on defense, while consumers and businessmen continued to spend at rates fa s te r than the economy could su sta in . The r e s u lt was the sta rt o f an in fla tio n a r y clim ate that except fo r temporary successes has never been broken. Instead o f mounting an attack when th is problem surfaced, the Federal government delayed and v a c illa t e d . a temporary b a s is . down spending. And, perhaps even more s ig n ific a n t ly , i t fa ile d to hold A ll of th is produced horrendous Federal d e f i c i t s that added to our in fla t io n . been in surplus; In f a c t , only once sin ce 1964 has the Federal budget and fo r the la st four y ea rs, i t has been in the red to the tune o f $65 b i l l i o n . I t fa ile d to increase taxes except on -3 - I b e lie v e that the unw illingness o f businessmen and consumers to reduce th e ir spending during the Vietnam c o n f l i c t and in s u ffic ie n t f i s c a l re s tra in t during and a fte r bear much o f the blame. only causes o f in fla t io n . But these are by no means the For example, some persons say that p rice s would have increased le s s i f the Federal Reserve had follow ed greater r e s t r a in t. In r e tr o s p e c t, th is is probably tru e, though in the main the in fla t io n r e sulted from a se rie s of d is tre s s in g developments. Who e ls e is to blame? was an important fa c t o r . That wages went up fa ste r than p ro d u ctiv ity Another was the devaluation o f the d o lla r . While a necessary step , i t had the e f f e c t o f making American products too a ttr a c tiv e in world markets. Acting as a stimulant to U. S. exports, i t cut in to domestic su p p lie s, notably food , and in th is way p rop elled U. S. p rice s upward. Along with these developments, we have experienced shortages. It used to be that you could buy almost anything you wanted as long as you could pay fo r i t . But th is has not been the case fo r some time now. It is true that g a solin e is no longer sca rce ; but s t e e l, c o a l, ce rta in kinds o f paper, and many other products are s t i l l in short supply. Booming w orld wide demand fo r many commodities and the embargo, in the case o f g a so lin e , are to blame in p art. To these events can be added the co n tro ls on p rice s and p r o fit margins that discouraged investment in some b a sic in d u strie s. Environmental co n tro ls further com plicated the s itu a tio n . A ll o f these fa cto rs generated shortages; and, o f cou rse, shortages give r is e to higher p r ic e s . The poin t o f th is r e c it a t io n o f reasons fo r the in fla t io n is to suggest that there has been no one v i l l a i n , but a great many. Indeed, I b e lie v e - 4 - that those who blame the high prices on a single factor oversimplify a problem that reminds one of the many-headed Hydra. Nor has the problem been m ostly one o f soaring food and fu e l p r ic e s . True, higher energy and food p rice s were re sp o n sib le fo r 60 percent o f la s t y e a r 's consumer p rice r is e . However, the major impact is now coming from other commodities and from se rv ice s which have racked up very rapid p rice increases th is year. There is c e r t a in ly no sign y et o f any marked slow ing in in fla t io n . On the con tra ry, the record-breaking August r is e in w holesale p rice s and the b ig jump in farm p rice s that follow ed e a r lie r d e clin e s could make lia r s o f those p re d ictin g the worst on the in fla t io n fro n t is over. And as I look more deeply at the p rosp ects, I am p a r tic u la r ly disturbed at the emerging pattern o f wage in cre a se s. Wage gains fo r co n tra cts that include c o s t o f liv in g adjustments have averaged out a b it more than 10 percent thus far th is year. R ising wages have long put upward pressures on c o s ts and, hence, on p r ic e s . Quite fo rtu n a te ly , 1973 proved to be an e x ce p tio n . rates la s t year rose much less than p r ic e s . In f a c t , wage I t i s , th e re fo re , understand able that workers are demanding greater pay ra ise s th is yea r. What concerns me about these ra ise s is th at, unless p r o f it margins get pinched, the in crease in labor c o s ts is passed along in higher p r ic e s . I express th is concern about soaring wage hikes hot because I am o b liv io u s to the fa c t th a t, taking account o f the r is e in p rice s and ta xes, the takehome pay o f fa c to r y workers has d eclin ed by about 5 percent th is past year. That is a dramatic drop in purchasing power and in economic w e ll-b e in g and underscores the tragedy o f in fla t io n . -5- Workers, o f cou rse, have not been the only group fe e lin g the pinch. Savers, r e t ir e e s , and others have a l l paid d ea rly . Check with them about what they have l o s t , not only in terms o f income, but in savings, fin a n c ia l a sse ts, and--not the le a st--p e a ce o f mind. The consequences o f in fla t io n do not stop th ere. opinion has accepted i t as a tra n sito ry m isfortune. In the p ast, m ajority When p rice s rose ra p id ly , most Americans would cut down on th e ir spending, trim th e ir s a i l , and try rid in g i t out. But when people think in fla t io n has become a permanent way o f l i f e , they begin to rea ct d if f e r e n t ly . Expecting p rice s to go ever upward, they throw caution to the wind and rush to buy products before p rice s go up even fu rth e r. Such a rush to buy can compound an in fla t io n , while the expectations o f s t i l l more in fla t io n w i l l eventually discourage people from saving. an environment. Home co n stru ctio n would not fin d financing in such State and lo c a l governments, co rp o ra tio n s, and other borrowers would not be able to finance th e ir needs. Economic growth would be severely c u r t a ile d . The impact o f ra p id ly r is in g p rice s would f a l l h ea vily on the low and middle income groups. than our income. The co s t o f everything we buy would go up fa ste r Everyone, fo r example, would lose i f things d eteriora ted to what Germany, fo r example, experienced during the h y p e rin fla tio n o f the m id-1920s. In c it in g these dangers, I do not wish to leave you with the impression that th is country is about to experience a su p e rin fla tio n or even a Latin American type, where p rice s increase in double d ig it s each year. wish to r e it e r a t e the dangers. I simply These are e s p e c ia lly relevant to us today, not only because p rice s in th is country have been increasing at a fa ste r than 10-percent rate but because the longer an in fla t io n is allowed to e x is t , -6- the more it becomes entrenched. harder it is to eradicate. And the more entrenched it becomes, the In fact, even in recessions, when one might expect reduced demand to bring about lower prices, prices rarely fall because our economy is not as competitive as it once was. The record shows that price reductions during recessions are commonplace only in those sectors where competition is still strong. This brings me to an issue that has received increasing discussion. This is the view that inflation is inevitable and the further view, some times given in the same breath, that we should begin to live with it. Professor Milton Friedman, for example, has stated that we ought to start a process by which we regularly compensate for inflation. advocated is a broad system of indexing. What he has Under indexing, the value of assets (wages, rents, and so forth) are adjusted for price increases. You can find examples of indexing or escalator clauses in recent aluminum, steel, and can workers' contracts, where wages are adjusted automatically for increases in the Consumer Price Index. Brazil uses this device extensively. Not only are workers compensated for their loss of purchasing power, but Brazilian banks and savings institu tions will all correct accounts with an amount equal to the rate of inflation. Loans, mortgages, bonds, personal tax exemptions, and tax brackets are similarly adjusted for higher prices. Hailing the success Brazilians have had in trimming their price increases, which incidentally are still much greater than ours, Professor Friedman and others believe the U. S. economy should copy Brazil and have indexes for wages, interest payments, financial assets, business accounting practices, taxes, legal obligations, and other contracts as a form of coping with inflation. -7- Now, one need not belittle Dr. Friedman's many contributions to conclude that when it comes to his view on across-the-board indexing he is absolutely wrong--wrong, indeed, on several counts. First, on a strictly technical level, there is nothing magical about indexing. Right now, for example, there is a heated dispute going on over the way the official price indexes in this country are constructed. are enormous. The technical difficulties of indexing Secondly, even if perfect price indexes could be developed, some groups are bound to come off second best in the correction process. Thirdly, some things are impossible to index. for money. That is especially true Can you imagine anyone wanting to hold money in an economy where most everything is indexed? I cannot. Indexing, to my way of thinking, is not what it is cracked up to be. On the contrary, it has serious shortcomings. Indexing could give momentum to a still faster price spiral as people become convinced there is no longer a need to fight inflation. The more people learn to live with inflation, the less reason they have to take actions correcting it. To suggest that indexing is a way of living with inflation means throw ing the towel, and to some of us old-fashioned people it is almost unthink able that our country would be part of accepting inflation as a permanent way of life. It seems to me that there should be enough statesmanship and common sense to deal with it directly and forthrightly. How then can the inflation be countered? From what I have said before, it should be clear that the economy has been on an inflationary bent for a long time and for a great many reasons. Therefore, I believe it will take not one but many different actions, ranging from greater production to greater leadership. -8- Such an attack must c e rta in ly include f i s c a l and monetary r e s t r a in t. This, in turn, requires statesmanship not only by the Federal Reserve but a lso by the Adm inistration and the Congress and the necessary fo rtitu d e to act in ways they know w il l re stra in p rice pressures. R estraint--w hether f i s c a l , monetary, or any other k in d --is unfortunately never p a in le ss. Can i t be achieved without some adverse e f f e c t on jo b s , on housing, or on other economic programs? The answer most experts would g iv e to th is question i s , o f cou rse, "N o." F is c a l and monetary re s tra in t i s , th e re fo re , o fte n unpopular and requires support from key business leaders and opinion molders such as you. On the other hand, what ch oice is there? is never easy. There w i l l be rough days ahead. A fter a l l , b a ttlin g in fla t io n But i f we continue to accept in fla t io n at recent ra te s, we w i l l pay a far greater p rice in the long run than i f we accept some d is lo c a tio n s tem porarily. I b e lie v e the way to deal with in fla t io n is to fig h t i t , not to liv e with i t .
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