Abstract: Financial markets have been on edge most of the year over prospects of an acceleration in inflation. The Federal Reserve began pushing up interest rates in February to head off price pressures and has moved fairly aggressively during the past several months. But have the moves been too late? Are we leaving the low inflation track enjoyed during the past three years? Alternatively, is the Fed tilting at windmills or at phantom price pressures that carry little risk of developing? Examination of economic recoveries during the past 30 years demonstrates that inflation does have a nasty tendency to move higher as the expansion matures. Exceptions have been few. We analyzed inflation performance early and late in the seven expansions since 1958. Core inflation (the rise in consumer prices excluding food and energy) was stable at 1.3% to 1.4% in the 1958-60 period. Inflation dipped slightly in the 1980-81 time frame, but the decrease from about 12% to 11% was hardly impressive. Nevertheless, numbers for the current cycle are encouraging. We are now in the fourth year of expansion. Yet, over the past six months, core consumer prices have been rising at an annual rate of 3.1%, in contrast to a core inflation rate averaging 4.0% during the first six months of the recovery. Although supply shocks, such as oil embargoes, wars, or crop damaging floods, can cause some prices to temporarily skyrocket, the general rise in prices, or inflation, has at all times and all places been, at heart, a monetary phenomenon. If money growth is too rapid relative to the economy's productive potential, prices will rise. If the economy is operating below potential, above-average growth can be tolerated for a while without pushing up prices. As excess capacity is absorbed, money and spending growth must be curbed or inflation will accelerate. Although different measures of the money supply have shed conflicting evidence on the strength of total spending in the U.S., nominal GDP has clearly been too rapid during the past few quarters to keep inflation contained. During the past year, nominal GDP has climbed by more than 6%. If we had not possessed some slack in the economy, the inflation outlook would already be deteriorating. One reason for optimism about inflation is that the U.S. economy is still operating below its full employment potential. Currently, it appears that we have spare capacity equal to about 2.0% of total GDP (see chart). With productivity growth still healthy, the economy can probably grow 2.7 to 2.8% per year without inciting higher inflation. Meanwhile, the Federal Reserve is likely to cool the economy down to a growth rate averaging about 2.5% during the next few quarters. This would mean that the expansion could continue without an inflation flare-up. Steep commodity price increases in coffee, oil, and copper have captured the hearts of all true bond bears this year. However, while commodity prices offer good information on industrial activity, they are poor forecasters of broad inflation trends. …
Publication Year: 1994
Publication Date: 1994-10-01
Language: en
Type: article
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