GETTING CONCERNED ABOUT INFLATION? FEAR NOT
Is the inflation monster beginning to stir? The U.S. economy is picking up. Prices of industrial materials are surging. Consumer prices jumped in January. President Clinton's broad energy tax sounds inflationary. The Japanese yen is at a postwar high, and the protectionist tone of the Administration is also a red flag for prices. Should you worry?
Relax. With so much underutilized labor and capacity, both here and abroad, the conditions for a sustained acceleration of inflation are unlikely to develop before 1995--if then. That's especially true if President Clinton's budget plan becomes law. The package is mildly stimulative this year and in early 1994, but afterward, it is somewhat contractionary--and thus disinflationary.
On that point, the bond market agrees wholeheartedly. On Feb. 23, the rate on 30-year Treasury bonds closed at 6.82%, the lowest since their regular issuance began in 1977 (page 28). As a result, the yield curve for Treasury securities, the relationship between yields and maturities, has flattened since election day on Nov. 3 (chart). Moreover, the explosive rally that has pushed yields down nearly a full percentage point in only three months may still have room to run.
The rally reflects a sea change in bond-market attitudes. The bond gods are finally getting a whiff of something they have demanded for years: a serious attempt to cut the federal deficit. That kicks away the last prop under inflationary expectations, which have held long-term interest rates stubbornly high for so long.
With high hopes that Clinton's budget package will fare well on Capitol Hill, the bond market senses that the U.S. economy is on the road to a low-inflation, low-interest-rate climate not seen since the 1960s. If so, long rates have further to fall. Historically, bond yields have averaged about 3 percentage points above inflation. At 3% inflation, the 30-year yield has room to approach 6%.
Federal Reserve Board Chairman Alan Greenspan said as much during his twice-yearly testimony on monetary policy. He also said that because of the slack in resource utilization, the economy can grow "relatively rapidly" in the near term without igniting inflation.
How rapidly? Look at it this way. In the long run, the economy is able to grow about 2% to 2.5% without pushing up inflation. But even with the recent pickup in growth, the actual level of real gross domestic product is still far below its potential level. Because of that gap, real GDP could grow at a 4% pace for two years before breeding serious, economywide price pressures.
All this plays directly into the Fed's hands. The promise of low inflation and deficit reduction allows the central bank to sit back and put its feet up, while the bond market provides far more stimulus than the Fed ever could for the purpose of offsetting the pain of higher taxes and spending cuts. As a result, monetary policy may be on hold for months to come.
Even with Fed policy unchanged, a cut in banks' prime lending rate cannot be ruled out. The spread between the prime and banks' cost of funds is still historically high, and because of the drop in long-term rates, the Treasury securities that banks had gorged themselves on are not as profitable as before. Consequently, banks face greater competitive pressure to attract private-sector borrowers. That will be especially true in the easier regulatory environment that Clinton promised on Feb. 23.
Prices pressures are hard to see in any of the latest data. Although the consumer price index rose a disconcerting 0.5% in January--even excluding food and energy--the CPI rose only 0.1% in December. Over the past six months, there is no acceleration in either the total CPI or in the nonfood, nonenergy core index. Over the past year, core inflation remains in a downtrend (chart).
Even stubborn medical inflation shows signs of retreating. Costs are still rising faster than overall inflation, but the annual pace has fallen to 6.6%, the slowest rate in 412 years. It should slow further, given the Administration's efforts to control health-care costs.
The most inflationary part of the President's plan is the energy tax. However, most economists say the direct effects will be very small--perhaps 0.2 to 0.4 percentage points added to the annual inflation rate when the tax is fully phased in by 1996. Also, competitive pressures in a less-than-robust economy will prevent nonenergy companies from passing through a large portion of the tax.
Looking broadly, restructuring and attempts to cut costs and boost productivity in the service sector will continue to hold down unit labor costs and retard service inflation. And stiff international competition will keep goods inflation in check, as long as sweeping protectionist measures are avoided, which for now seems likely.
The outlook for inflation is upbeat even with the faster pace of the industrial sector. That's because orders and output still have a long way to go before they begin to strain capacity. Although operating rates are on the rise, they remain firmly below the 83%-to-85% range usually associated with upward price pressures.
Goods producers have looked increasingly healthy since September. Industrial production has risen for four months in a row. In January, it posted a 0.4% gain, while output in manufacturing jumped 0.6%.
Resilient demand should keep factory assembly lines busy in coming months. True, new orders for durable goods dipped 1.7% in January, but the loss hardly reversed the 9.6% surge in December bookings. Also, unfilled orders edged up 0.4% in January, after a 0.3% rise in December.
Further orders gains are likely, given continued strong reports from retailers on consumer buying. Although the Conference Board's index of consumer confidence dropped nearly eight points in February, to 68.5 (chart), the decline probably reflects subsiding election euphoria and the month's highly visible layoff announcements at a few large companies. Also, the survey was taken before Clinton's Feb. 17 economic message, which households received favorably.
In addition, recessions in other industrial countries have not yet triggered a slowdown in foreign demand. In December, U.S. exports jumped 4%, to a record of $39.7 billion. Imports also rose, but by a smaller 2.5%, to $46.7 billion. As a result, the merchandise trade deficit narrowed to $7 billion, from $7.3 billion in November.
After adjusting for prices, exports grew at an impressive 24% annual rate last quarter. Poor seasonal adjustments may have exaggerated that advance, but even so, foreign trade remained a solid contributor to U.S. growth at the end of 1992.
That should change this year as the downturns abroad finally hit the demand for American goods and as the U.S. recovery draws in more imports. In particular, the proposed investment tax credit will lift imports of capital goods even as it boosts orders for U.S.-made equipment.
Historically, the weakness of the U.S. dollar, especially against the Japanese yen, would cause the inflow of imports to be inflationary. But this time, past may not be prologue. The abundance of unused capacity all over the world suggests that many companies will have to forgo price hikes in order to defend--or expand--market share.
Indeed, despite the new verve in manufacturing, a lot of production capacity remains under wraps in the U.S. In January, the operating rate for all industry rose to 79.5%, from 79.3% in December. That's still way below the 83.8% reading hit just before the 1990-91 recession (chart).
Increased competition--both global and domestic--may well prove as fierce a deterrent against inflation as any action taken at the Fed or on Capitol Hill. That's not to say the inflation beast will never roar again. But for the next few years, the monster seems incapable of letting out much more than a whimper.JAMES C. COOPER AND KATHLEEN MADIGAN