Federal
Reserve Bank Washington,
D.C.
THE NEW ERA AND LIKELY FED POLICY
The paradigm of the New Era suggests that high economic growth is possible without increasing inflation. Factors generally cited include globalization, increased productivity, and technological change. In this study we suggest that a rapid disinflation in the CPI for manufactured goods has caused decreased growth in the overall Consumer Price Index since 1991. This CPI also explains inflation in the U.S. since 1979. We comment upon a paper by David Brauer of the New York Fed and also upon the likely effect of the currency crisis in Southeast Asia.
Inflation
is a phenomenon abetted by inappropriate monetary policies. Econometric
analysis tracing its distinct causes, however, has not been explanatory due to
the leads and lags involved.
David
Brauer of the New York Fed has just published a paper titled “Do Rising Labor
Costs Trigger Higher Inflation?” Brauer examined the hypothesis that wage
increases cause price increases, a crucial link in the Phillips curve concept.
He classified the components of the Consumer Price Index into three broad
categories: labor-cost sensitive services, labor-cost sensitive goods, and
other expenditure categories.
Using
data between 1983-1997, he found that the linkage between wages and prices has
been slightly positive in the service sector of the economy (22.8% of the total
CPI), non existent in the manufacturing sector (19.4% of the total CPI), and
irrelevant in other sectors (57.7% of the total CPI). The total effect of a 1%
increase in wages in the service sector is only .2% on the overall CPI after
more than nine months. Price increases are likely to be the most important
proximate causes of inflation.
This
analysis suggests a method of determining what causes change in the overall
Consumer Price Index. If we assume that the manufacturing CPI from the Brauer
study and oil prices are the independent variables, the resulting regression
explains 90% of all inflation in the United States during the years 1979-97 (9
mo.):
Consumer Price
Inflation = 1.21 * Chng Mfr. CPI + .04 * Chng Oil Prices + .97
Sources: Bureau of Labor Statistics, Department of Labor
Energy Information Administration, Annual Energy Review
The
manufacturing CPI is statistically significant at the 0% level. Oil prices are
significant at the .1% level. Change in the manufacturing CPI predicts 85% of
all inflation, although it accounts for only 19.4% of total consumer
expenditures.
A
1% change in the manufacturing CPI can be expected to cause a 1.2% change in
the total CPI. Inflation is caused more by excess demand than by costs.
If
we examine trends in this manufacturing CPI from the Brauer study, we can see
that it decreased during the years 1984-1986 and during the years 1991-1997.
The
reasons for pricing restraint were different during each period:
1984-1986
This
CPI decreased because Paul Volker applied severe restraint to the economy,
raising the Fed Discount Rate to an average premium of 4.3% over the rate of
inflation. This premium should be compared with a thirty-seven year average
premium of 1.7%.
1991-1997
Since
the real Fed Discount Rate during this period has been low, another explanation
for this present period of low inflation is warranted. The causes of recent
decreases in the CPI for labor-cost sensitive manufactured goods are largely
supply side.
In an article in Foreign Affairs (1997) titled "The End of
the Business Cycle?" Steven Weber sums up the New Era arguments:
"...modern economies operate differently than
nineteenth-century and early twentieth-century
industrial economies. Changes in technology
ideology, employment, and finance, along with the
globalization of production and consumption, have
reduced the volatility of economic activity in the
industrialized world."
The
current combination of low inflation and high overall labor force utilization
is due mainly to an excess supply of world-wide manufacturing capacity which
has increased domestic competition.
We
have identified the major components of inflation. We now investigate each in
the order of effect. The purpose of this is to suggest a possibly useful method
of reasoning from the salient facts:
1)
Manufactured Tradable Goods. Changes in this CPI component have a substantial
effect upon total inflation. During the time period studied, the Brauer article
found no statistical link between wages and this CPI component. This is the
reason that the Phillips curve has disappeared for this business cycle.
The
crisis in Southeast Asia has already resulted in 10-30% currency devaluations
in relation to the U.S. dollar in the eleven months since January, 1997. Many analysts
expect a .5% decrease in U.S. economic growth next year due to this crisis. We
think the major effect of this crisis will be upon prices. In 1996, Asia
including Japan accounted for $213 billion in imports, more than 9% of the
U.S.'s total manufacturing GDP. Since many imported products such as
automobiles, chemicals, and apparel compete directly with U.S. manufactures,
the ability of all producers to raise prices is likely to remain low. This
sector is therefore unlikely to be a source of inflation in the near future.
2)
Oil Prices. Political problems in the Mideast can always affect oil prices. Due
to technological progress, however, there is no fundamental reason why these
prices should increase appreciably. Since 1980, the world's proven reserves
have increased by 60% (Energy Information Administration).
3)
Service Sector Wages and Other Causes. The Brauer study has shown that a 1%
change in wages in the service component of the CPI has only a .2% effect after
more than nine months on the general CPI.
At
this 11/97 writing, the near term outlook for inflation in the U.S. is moderate
because growth in the manufactured goods CPI has been nil. Since there is some
bias towards inflation in the service sector, the Fed might increase interest
rates slightly over the intermediate term. As the markets continue to
reverberate after October 27th, we do not think that the extremes of optimism
or pessimism are justified. This is why there are institutions.