The Great Inflation: Some Perspective

Inflation is a word that we are familiar with because it is described to us so often. It is "moderate", it is "well behaved", "benign", "contained", "under control", "no problem", "tame", etc. The minutes of the Federal Reserve Open Market Committee utilize these descriptions routinely: "Against the backdrop of slowing economic growth, core inflation had remained quiescent. Views regarding the outlook for inflation were somewhat muted, though all the members agreed that the risks of higher inflation had diminished materially." (12/19/00)

Those of us whose memories go back 60 to 70 years will find these terms less than forthright. In that earlier period a postage stamp cost 2 cents, transportation fare (in Pittsburgh) was 8 1/3 cents (three tokens for a quarter) while today it is $1.60. A standard candy bar or ice cream cone was 5 cents, gasoline cost 16 cents per gallon, a Richman Bros. four-piece all wool suit cost $21.50, and a new Ford or Chevrolet cost about $650. A little reflection will lead to the conclusion that the prices of these items have increased from 10 to 20 times in about 60 years. This conclusion is bolstered by the following chart that shows two broad measures of inflation over the past 40 years.

The consumer price index based on 1982-4=100 goes back to 1958 when the index was 28.9. In April of this year it was 176.9, about a fivefold increase in 43 years. The chain-type index for gross domestic product, an even broader measure, based on 1996=100 shows a similar result.

These increases do not seem so "moderate" when you lengthen the period of comparison beyond the one year observers are prone to cite. The reason is that inflation is like compound interest - the rate applies to an ever-growing base. As every investor knows, one of the most effective ways to increase wealth is through compound interest, and one of the surest ways to devalue a currency is through persistent "low" inflation.

Two other things are worth noting in the chart. One is that the trend turned upward noticeably after 1970, and the other is that the trend has been fairly constant since then. The "oil shock" of the l970s in retrospect turns out to have had only a limited impact on trend.

The Bureau of Labor Statistics breaks down the consumer price index into major categories, summarized as follows:

CONSUMER PRICE INDEX 1982-4=100
	1960	1970	1980	1990	2000	% change 1960-2000
All items	29.6	38.8	82.4	130.7	172.2	481.8
Food & beverages	30.0 *	40.1	86.7	132.1	168.4	461.3
Apparel	45.7	59.2	90.9	124.1	129.6	332.0
Housing	#	36.4	81.1	128.5	169.6	271.1 #
Transportation	29.8	37.5	83.1	120.5	153.3	414.4
Medical care	22.3	34.0	74.9	162.8	260.8	1,069.5
Other goods/services	#	40.9	75.2	159.0	271.1	672.4 #
Energy	22.4	25.5	86.0	102.1	124.6	456.3
* Food only # 1967 first data available

Several things are noteworthy in this chart. As already noted, the index grew almost fivefold in 40 years. But the rate of growth varied considerably among categories. Food and beverages grew slightly less than the index for all items, but apparel, housing, and transportation grew considerably less. These four items can be viewed as "basic", and all grew less than the overall average. Medical care and all other items, on the other hand, grew much faster than the average - medical care especially, grew more than twice as fast as the average! Other goods and services includes personal care items, which have experienced above-average price increases in recent years.

The chain-type price indexes for gross domestic product measures broad sectors of the economy, broken down as follows:

As with consumer prices, we find wide variations among different sectors. Over the 40-year span, personal durable goods and nonresidential investment have experienced the least inflation, while services, residential investment, and government expenditures have experienced the most. Among personal consumption expenditures, durable goods rose the least while services rose the most, a finding that is consistent with the consumer price index. Some of the moderation in durable goods and nonresidential investment inflation has been due to declining prices for electronic components such as computers. Services inflation reflects steeply rising medical/personal care expenses, advertising costs, higher education costs, entertainment and recreation costs, etc. Government expenditures were strongly impacted by rising salaries.

If we look at just the last ten years, it is striking that consumer durable goods, nonresidential investment, and imports actually experienced deflation rather than inflation. The steepest inflation was in residential investment and government expenditures for goods and services.

These differentials indicate that no single factor such as money growth or public services (also labeled rising taxation or big government by right wing ideologues) can account for the great inflation. If they were responsible, we should expect them to impact the various segments of the economy shown above more or less equally. Instead we find such great differences as services growing more than four times faster than durable goods even within the personal consumption expenditures category.

G.L. Bach, a respected economist [Inflation, 1957, p. 36], wrote:

"First, there will be persistent inflationary pressures in the United States over the foreseeable future. Second, the roots of this pressure lie deep in our basic democratic political and social processes, as well as in our particular economic institutions, and this fact will make effective prevention of inflation unlikely, although there may well be intermittent periods of stable or even falling prices."

Bach believed that a national commitment to "full employment" lay at the heart of the inflation process. He theorized that "the income claims of major economic groups exceed the total national real income available at current prices, as each group puts up its asking price in order to increase its real income. Faced with this excess of claims, the government, committed to maintaining high level employment, will generally provide the additional purchasing power to support employment at the higher cost and price levels - indirectly through providing new money through the banks, or directly through fiscal policy." The commitment to full employment faded as a major policy goal long ago, and the mere statement that the government would provide purchasing power to support higher price levels is rather simplistic. But his insight that the inflation process is deeply imbedded in our economic and political processes is as valid today as when he pronounced it. Our current challenge is to identify what these processes are.

Historical Context

Due to its long continuance, we have been conditioned to believe that inflation is normal and is one of the marks of prosperity; price stability, on the other hand, labeled "stagflation" is associated with a weak economy. These concepts, however, do not agree with our past experience.

Quoting again from G.L. Bach (p 38}, after noting that every major industrial western nation has experienced periods of inflation, he asks the question:

"How have we done in the United States? Better than most. Each war or its aftermath has seen a huge peak of inflation - the 1780s, 1815, 1865, 1919-20, and 1945-51. War needs have diverted goods and men from civilian production, and new money has been created to pay for huge war outlays, rather than levying sufficient taxes to pay the bills. But in between these peaks, prices have dropped back toward, or even below, prewar levels. In the 1930s, for example, prices were little if any higher than a century before. And during the last third of the 19th century, a persistent downdrift of prices carried them below their bottoms of the preceding century. Except in war, the prodigious productivity of the expanding American economy has made it hard for inflation to get a toehold. Though total spending has risen decade after decade, the goods and services poured out into the market have risen apace. Until at least the post-World War II period, the history of the American economy provides little support for the fear of inflation, except in connection with war"

It is particularly interesting to note "during the last third of the 19th century, a persistent downdrift of prices carried them below their bottoms of the preceding century". This was a period of tremendous geographic as well as industrial expansion with persistent labor shortages relieved by waves of immigration, yet prices tended to fall because productivity was rising. This experience directly refutes the current dogmas that inflation results from too low unemployment or an "overheated" economy. These dogmas ignore basic economics which tell us that firms cannot push wages above what they can recover in the price of their product - and that they cannot arbitrarily raise prices just because they have increased their costs. If they could do that, they would never incur losses, which we know they do. The market still determines prices in most industries, and firms must conform to it.

This perspective does not address the reasons for the current inflation or the mechanisms that are causing it. These aspects, however, must be investigated if we are to understand today's economy.

The five economies showed pronounced weakness in the first half of 2001, with GDP growth only half or less as great as in 2000 except in Britain where it was down about a fifth. Industrial production fell slightly except in Germany.

Retail sales weakened in Canada and Japan but were fairly stable in the other three economies. Consumer prices, however, continued their steady uptrend except in Japan which has now experienced five years of virtually steady prices. The unemployment rate fell in Germany and Britain while edging upward in the other three.

Central banks are attempting to drive interest rates down in the hope of stimulating growth. The experience of Japan, which has fostered zero rates, raises the question of whether this strategy will succeed. The current economic weakness is reflected most strikingly in the stock indices, which in all five countries are now not only below the 2000 level, but the 1999 levels as well. They have fallen further since the end of June with the Japanese index reaching a 17 year low - a reminder of just how far markets can decline.

Canada has been earning a trade surplus of $4 to $5 billion per month, with a hefty $25.5 billion current account balance. The Japanese current account surplus fell below $100 billion.

The U.S. dollar rose against major trading partners to its highest level in over three years.

As noted in Pulse #01-2, The Growth God faltered in the second half of 2000. Real GDP rose 1.6 percent in the second half compared with 5.2 percent in the first half. This weakness continued in the first half of 2001 as growth averaged 0.8 percent. The principal contributor to the slowdown was nonresidential fixed investment (structures, equipment, and software). Exports also declined but consumer spending and government spending remained positive as real disposable personal income increased 1.7 percent.

Industrial production peaked in September, 2000, at 149.0; by July 2001, it had fallen to 142.8 with declines in both durable and nondurable goods. Among final products, business equipment fell sharply whereas consumer goods was essentially flat. The capacity utilization rate is now the lowest in over a decade.

Manufacturers' new orders have been falling since the first half of 2000; the level of $332.9 billion at the end of June was lower than the preceding two years.

New construction spending has remained quite strong, although there were small declines in June and July. The contracts index was lower at the end of the period than at the beginning. Gross private investment peaked in the second quarter of 2000 at $1,801.6 billion and fell steadily to $1,665.4 billion in the second quarter of 2001. The decline was concentrated in nonresidential fixed investment and inventory levels. Residential investment has been steady. Since this is the area of weakness in the economy, it is difficult to see how interest rate cuts and tax cuts can have much impact.

The preceding point is reinforced by the sales figures for business and the retail sales to consumers. Business sales peaked in June 2000 and have trended lower since then, whereas retail sales have been higher every month since June 2000. The business inventory-sales ratio has risen slightly, but the retail ratio declined noticeably. The optimists who predict an upturn once "inventory liquidation" has run its course are likely to be disappointed.

Per capita consumption expenditures advanced to a new record in the second quarter of 2001, further demonstrating that consumer demand has been no factor in bringing on the downturn. Again, tax and interest rate cuts are not the answer.

In the current environment, the employment figures become critical. If employment growth falters, the foundation for the personal consumption boom will be undermined. We will also see a test of just how stable the services-based economy really is. Much of the service sector can be dispensed with if consumers really become pinched.

Total non farm employment has not risen since March, with an outright decline in goods-production. This interrupted a long rise that began back in 1991. The figure for August (132.3 million) was the lowest since November, 2000.

National income growth has been decelerating over the past four quarters; compensation of employees has remained strong, but corporate profits have been declining. Real per capita income (which reflects inflation as well as income) rose 1.65 percent in the first half compared with 2.6 percent in 2000. Average real weekly earnings fell for the first time since 1995 as average hours worked per week declined.

In August the Bureau of Economic Analysis published revised estimates of the national income and products accounts to include new data, methodological changes, etc. Under these estimates, personal saving for 1997-2000 was revised upward while business and government saving were revised downward. The personal savings rate for the first half of 2001 shows an increase over 2000.

The commodity price index sank even further in the first half to 68.2 from 100 in 1995. Producer prices were virtually unchanged through the half but higher than the 2000 average. It is interesting to note that despite a collapse in commodity prices and little change in producer prices, the consumer price index rose at about the same rate as in 2000.

Corporate profits continued to decline in the first and second quarters, with the largest decreases in the durable goods, manufacturing, transportation and public utilities group, and financial corporations, especially insurance.

The M-3 money supply exploded to more than 13 percent annual rate in the months April through July although non-financial debt growth was below 5 percent, and commercial bank credit advanced only moderately. The money supply seems to have taken on a life of its own. Meanwhile, F.R. open market operations have been subdued, especially in view of the repeated cuts in the targeted federal funds rate.

Credit market debt consists of domestic non-financial, domestic financial, and foreign sectors. Within the domestic non-financial sector, household debt grew 8.5 percent in the first half of 2001 compared with 8.4 percent in 2000, and business debt grew 6.3 percent compared with 10.0 percent, its lowest rate since 1996.

The negative balance on goods and services fell slightly in the first half of 2001 as exports and imports declined. Both exports and imports declined for the third consecutive quarter; the declines in imports came after 38 consecutive increases.

The negative international investment position of the U.S. grew substantially in 2000, primarily due to record inflows of foreign capital. Valuing direct investment at current cost, the net position grew to $-1,842.7 billion, equal to 18.7 percent of GDP. Most foreign currencies depreciated against the U.S. dollar during 2000.

During the decade of the 1990s, the U.S. net negative position increased $-1,597.3 billion or an average of $159.7 billion per year. This [unsustainable] capital inflow has been one of the primary props underlying the boom of the '90s.

U.S. direct investment abroad continued to exceed foreign direct investment in the U.S. in 2000, but the gap narrowed to less than $100 billion. Foreign holdings of U.S. Treasury securities declined whereas holdings of other U.S. securities, particularly of U.S. agency securities, soared. U.S. currency holdings abroad increased only slightly due to the large buildup of stocks in 1999 in anticipation of the century-ending date change.

Copyright © Andrew Caughey, 2001

The Pulse of Capitalism is published quarterly. Comments may be sent to Pulse Publication, P.O. Box 140, Gibsonia, PA 15044. Telephone: (724) 443-2396
Material may be reprinted with acknowledgement of the source. Economic statistics are revised routinely and may, therefore, differ from one report to another.

Published October 2001