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ZERO INFLATION IS NOT WORTH THE RISK
The death of inflation is fast becoming a fashionable topic of debate in the corridors of Washington and the halls of academe. Zero inflationists are battling New Economy types for control of policy. Both believe they know the elixir for faster economic growth. The zeroes, who include several regional Federal Reserve bank presidents and congressional conservatives, want to hike interest rates sharply to get to zero inflation now. The New Economy wing, which includes Fed Chairman Alan Greenspan and the National Association of Manufacturers, believes that new technology and global markets allow the U.S. to aim for faster growth with low-enough inflation. We think the zeroes are well-intentioned, but the New Economy folks are on target. This is not the time to stomp down hard on the economy.
Let's go to the tape. The recent data on the second quarter is a paean to the New Economy argument. It shows that even with a surge of 4.8% in gross national product, actual inflation remains low. The price deflator rose at a low annual rate of 2.1%, productivity rose a surprising 0.5% and hourly real wages actually fell 0.1% for the quarter. In the past, at this late point in a business cycle, productivity would be falling and labor costs would be much higher. Inflation would surely be rising more sharply as unemployment approached 5%. Something in the economy is different this time.
Look at prices. A few, such as gas, beer, and airline tickets are up. But pricing power, overall, remains weak, with the cost of cereal, paper towels, computers, Japanese luxury cars, and burgers actually declining. American Airlines pilots and McDonnell Douglas machinists just settled for job security, not big pay packages, and the United Auto Workers appears ready to do the same thing. Even gold bugs must admit that something is different. In 1990, when oil last surged, gold jumped $70. This round, with oil up 24% over the past year, gold remains totally tame. Could it be that this business cycle is different because it is investment-led? That greater capacity, higher productivity, and global competition are restraining companies from passing on higher wage cost and igniting what, in the past, would already have been dangerously higher inflation? We think so.
We also believe that the Fed can't risk being cavalier. Unit-labor costs are running ahead of inflation for the year. A small hike in short-term rates is totally compatible with a New Economy view. As long as monetary policy isn't used to strangle the economy to get to zero inflation, a rise of 25 basis points might reassure the markets that the Fed is vigilant.
If the economy were not showing clear signs of being transformed into a higher-growth, lower-inflation machine, there might be an argument for the zeroes' case. Real savings would be higher under complete price stability. But given the five-year success of the New Economy--great corporate profits, big capital spending, and very low unemployment at a cost of a bare uptick in inflation--the pain of getting to zero isn't worth it. The deflationary cost of zero inflation would be lost economic growth and higher unemployment. For what?
Business people think their companies and their markets have changed because of technology and global competition. These New Economy CEOs just may have a better feel for productivity and prices than statisticians collating inadequate data. This is especially true if, as many suspect, government statistics overestimate inflation by one percentage point. The Fed has already launched a successful experiment in lowering the "natural" rate of unemployment from 6% to 5% without igniting dangerous inflation. Shooting for zero inflation is too risky. Times are good. We shouldn't blow it.