FRBSF Weekly Letter
96-09; March 1, 1996
This Weekly Letter is adapted from recent speeches given by Robert
T. Parry, President and Chief Executive Officer of the Federal Reserve
Bank of San Francisco.
Inflation played a key role in the Fed's decisions to lower the federal
funds rate by a quarter percentage point in December and then in January
(and also to lower the discount rate by 25 basis points in January). Our
official press release in December explained that, "Since ... July,
inflation has been somewhat more favorable than anticipated, and this
result, along with an associated moderation in inflation expectations,
warrants a modest easing in monetary conditions."
Favorable inflation trends also were prominently mentioned in the January
announcement: Moderating economic expansion in recent months has reduced
potential inflationary pressures going forward. With price and cost trends
already subdued, a slight easing of monetary policy is consistent with
contained inflation and sustained growth.
In these remarks, I d like to review the nation s recent inflation performance,
and I d also like to present a few of the concerns I have about the inflation
developments we might encounter in the years ahead.
The recent performance of inflation has been encouraging. Since May of
1995, there's been a string of low numbers for the consumer price index--for
example, the so-called core CPI (the CPI excluding the volatile food and
energy components) has risen at a 2-1/4 percent rate. That's much better
than the 4-1/4 percent rate we had in the first part of 1995, and it also
beats the average rate for 1994, which was 2 percent. Inflation expectations
also have come down recently. For example, the latest Philadelphia Fed
Survey of Professional Forecasters indicated that the drop was significant--inflation
expectations ten years ahead fell from 3-1/2 percent at the end of 1994
to 3 percent at the end of 1995. A half percentage point drop over a year
is significant because, for some time now, expectations have tended to
move down at a "glacial" pace.
These favorable developments on the inflation front certainly are welcome
news, and they support the recent modest declines in the funds rate on
several counts: First, the decline in long-term inflation expectations
should directly relieve inflationary pressures. Second, the recent drop
in inflation essentially meant that the "real" funds rate had
risen--in effect, making policy "tighter" than before. Our recent
actions undid that.
In addition, the pace of economic activity seems to have slowed somewhat
in recent months, and this also may help relieve inflationary pressures
and provide another reason for easing policy. However, there are a couple
of temporary factors--the blizzard on the East Coast and the partial government
shutdown--that cloud our view of economic trends at present. It's tough
to tell if the economy has entered a slowing phase, or if signs of recent
weakness will be largely erased once we see the data that is collected
after the blizzard and the shutdown.
Although I'm pleased with recent inflation developments, my main message
today is that I wouldn't want to go overboard--that is, I wouldn't want
to say that our modest reductions in the funds rate mean that we agree
with those who say we've won the battle on inflation. For example, not
too long ago, a Wall Street Journal article quoted
a strategist from Salomon Brothers who said, "This time, the Federal
Reserve has slain inflation." And U.S. News and World Report
devoted a full article to the subject: Their headline was, "Conquering
Inflation--The Monster that Menaced the Economy Has Met Its Master."
Frankly, I just don't think such unbounded optimism about inflationary
pressures is justified. In fact, I think there's room for uncertainty
about potential pitfalls the Fed could face in pursuing its goal of price
stability. That s why it s important to think carefully about what s right,
what s wrong, and what s far from clear in some of the stories people
tell about inflation trends in the future.
Let me begin by disposing of one of the least compelling arguments about
a rosy inflation outlook. Some people think there's little reason to worry
about inflation anymore because of the so-called "globalization"
of markets. According to this view, world capacity, rather than U.S. capacity,
is what determines U.S. inflation. There are at least a couple of things
wrong with this line of thinking. And, if you were at the Annual Meeting
of the National Association of Business Economists in September, you may
remember my long harangue on the subject (Parry 1995). I pointed out that
the U.S. economy is actually less integrated into the world economy than
most people think. According to one rough estimate, 70-80 percent of U.S.
output is not traded internationally. That means that a very sizable part
of our economy isn't directly sensitive to foreign price factors.
I also emphasized that, even considering the prices of goods traded internationally,
the effect on U.S. prices is offset to a large extent by our policy of
flexible foreign exchange rates. For example, suppose the price of steel
is lower in Japan than in the U.S. When U.S. manufacturers buy Japanese
steel, they have to pay for it in yen, and in the process, they bid up
the yen relative to the dollar. As the yen appreciates, the cost of Japanese
steel to U.S. firms goes up--even though the Japanese haven't changed
the yen price they charge! Of course, in the real world, exchange rates
don't offset international developments perfectly: A few of our trading
partners do fix their exchange rates to the dollar, and some others don't
let their currencies float with complete freedom. In addition, it may
take time for exchange rates to adjust. But that doesn't change the basic
point that we can't depend on foreign capacity to keep U.S. inflation
The next issue I'd like to touch on is the recent slowdown in the growth
of labor compensation costs. The employment cost index rose at a 2-1/2
percent rate in the first three quarters of 1995, compared to 3 percent
in 1994. And according to some observers, this downward trend will continue,
keeping price inflation down as well. But I'm not completely convinced
on this point, because all of the decline in labor cost inflation has
been due to moderating benefits costs. They decelerated to only a 1.3
percent rate in the first three quarters of 1995, compared to around a
4-1/2 percent rate in 1994.
A good part of the reason for this, of course, is that firms are holding
down medical costs by switching to managed care and other medical cost-containing
programs. We've certainly done it at the Fed, and I'm sure many of your
companies have as well. Now, this switch may very well have permanently
lowered the level of benefit costs. But it can't permanently reduce the
rate of change in benefit costs. After all, eventually this route to cost-savings
will come to an end. [Editor's note: According to the February 13th
release, the Employment Cost Index did rise at a faster rate in the fourth
quarter than earlier in 1995 because of a surge in benefits costs.]
Moreover, even if benefit cost inflation does stay down a while longer,
total compensation may not. Workers and firms care about total compensation,
including wages, salaries, and benefits. As a result, persistently low
benefits costs may eventually show up in higher wages. So, at some point,
we may see a reversal in the recent downward trend in labor cost inflation.
Measures of capacity in the U.S. economy present some uncertainty as
to whether there currently is much downward pressure on inflation. First,
capacity utilization in manufacturing stands at 81.8 percent, which is
within the range of estimates of full utilization (Garner 1994). Of course,
no such estimate of where the economy is relative to its capacity to produce
is perfectly precise--but still, this is one measure that suggests that
there is essentially no downward pressure on U.S. inflation at present.
We get basically the same impression from the unemployment rate. By some
estimates, the current 5.8 percent unemployment rate suggests that we
have overshot capacity. Specifically, this rate is below the 6 percent
rate that has often been invoked as the so-called "natural rate"--that
is, the rate the economy can sustain without creating inflationary pressures.
But measures of the natural rate are as imprecise as measures of full
capacity utilization, and they also must be interpreted cautiously (Staiger,
Stock, and Watson, 1996). For example, a number of analysts have suggested
recently that the natural rate has fallen below 6 percent. One explanation
often given for the decline involves changes in the structure of the labor
market, in particular, the growing role of temporary workers, who have
less strong ties to the labor market. But, even if the structure is changing,
and even if the natural rate has fallen, the current 5.8 percent unemployment
rate still provides a reason to be cautious about the inflation outlook.
For example, if you assume a drop in the natural rate--say, to 5-3/4 percent--then
our model simulations say that putting inflation on a downward trend would
not be a painless process.
I started out by saying that, while the inflation picture has improved,
it's important not to exaggerate what that improvement means. As I've
tried to argue, it doesn't mean that the battle on inflation has been
won. On the contrary: The Fed's goal is to move towards price stability
over time. And we're not there yet. One clear indication of this is survey
results on inflation expectations. I mentioned at the outset that inflation
expectations of professional forecasters have declined over the past year,
and that this was one of the reasons that we could reduce the federal
funds rate. However, I also would like to point out that at 3 percent,
expectations of inflation both one and ten years into the future remain
at levels well above our goal of price stability, and also above recent
favorable inflation results.
In my remarks today, I've mentioned a few of the areas of uncertainty
we face in making progress toward price stability--such as whether there
is any excess capacity in the economy, and how much longer benefit costs
will continue to moderate. To make our way in the face of these uncertainties,
we'll need to maintain our vigilance and be prepared to respond to new
information on issues such as those I've discussed today.
But one thing about which there's no uncertainty is the reason for our
goal of price stability--that is, through a policy of delivering low and
stable inflation, the Fed makes its best contribution toward enhancing
the standard of living available in our nation's economy.
Robert T. Parry
President, Federal Reserve Bank of San Francisco
Garner, C. Alan. 1994. "Capacity Utilization and U.S. Inflation."
FRB Kansas City Economic Review 79, pp. 5-22.
Parry, Robert T. 1995. "Monetary Policy in a Dynamic, Global Environment."
FRBSF Weekly Letter 95-38 (November 10).
Staiger, Douglas, James Stock, and Mark Watson. 1996. "How Precise
Are Estimates of the Natural Rate of Unemployment?" In Monetary
Policy and Low Inflation. NBER Conference, Cheeca Lodge, Islamorada,
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
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