“In all but the shortest of terms, it is the Federal Reserve’s policy that determines how much inflation there is, and we’re going to make sure that the inflationary impact that may come from the weakening dollar is not passed into broader prices and become part of the underlying inflation rate.”
We begin with a footnote.Ben Bernanke, December 8, 2007
testimony before the Joint Economic Committee
The Federal Reserve Board began the post-war period with a very limited role in fighting inflation. Prior to 1951 and the so-called Treasury Accord, the Fed was semi-independent, perhaps more independent than other agencies, such as the FDA or FCC, but not so much as today. That is, the Fed was not attached to any specific cabinet department, but it made policy in close consultation with the Administration. This was a legacy of both the Depression era and the War years. The Truman administration used its influence over interest rates very effectively to keep debt service on war bonds down. But that changed in 1951. Between 1951 and the late 1970s Federal Reserve action was limited. During long periods, such as during the expansion of the Kennedy-Johnson years, interest rates stayed low and stable. That changed with the activism of Paul Volcker in the late 1970s and continued under Chairman Alan Greenspan who took over in 1987.
Today we are going to look back and touch on a few anecdotes that illustrate who actually did fight inflation during those years. But first the current context.
Inflation pressures today arise from higher commodity prices, prices which have accelerated coincident with the fall of the dollar and the collapse of mortgage lending. Oil, metals and food prices, particularly, will hit consumers hard in the upcoming months. Food inflation worldwide is a potential humanitarian debacle. We’ll go into that issue more deeply in a future podcast.
Inflation has been subdued over the past fifteen years. The Clinton era benefitted from very low oil and energy prices, but all years since 1980 have benefitted from – if benefit is the correct term – stagnant wages. Productivity has increased seventy percent. Wages have not.
Headline inflation, which includes fuel and food, has been followed less closely in recent years than core inflation, which does not include these two categories. What does core inflation consist of? Breaking it down past the sectors, it consists of wages, other manufacturing inputs and imported goods. If imports, fuel and food increase in price, we have the recipe for a classic cost-push inflation. If inflation is kept down, it will be at the expense of wages.
Wages are sticky. That means payrolls are not cut by reducing the wage rate, they are cut by letting people go. It is a trademark of the American economic ship since 1980 that when we need to keep afloat, we don’t bail the water out, nor even throw over some of the heavier goodies from the A deck. Instead we start tossing in the marginalized and even the crew.
But the cost-push, demand-pull distinction is lost on the Fed, which treats all inflation price rises as incipient spirals. How was it done before Volcker-Greenspan?
After World War II, Truman kept the war-time price controls on as long as Congress would allow. He supplemented this by reducing the size of government as fast as possible. He did this in the face of seven million men under arms returning to the work force. The domestic economy was scrambling with pent-up demand meeting industries frantically retooling from the war. World-wide need caused enormous demand for American products, particularly food, and commodity prices rose dramatically.
Truman steadfastly refused to shut down the economy with higher interest rates, and instead encouraged elimination of bottlenecks and mitigation of higher wage demands from workers in many industries who felt they had foregone a share of the booming war years for the good of the country, and now that the war was won, it was their turn. Truman also famously broke a railway strike by threatening to call in the Army to run the rails. But if inflation is too many dollars chasing too few goods, the Truman plan was to increase the number of goods, not reduce the number of dollars.
When the Korean War arrived, a coordinated cutback in domestic industry kept the economy from overheating. Let’s say it came at the cost of a ‘52 Chev.
Kennedy employed wage-price “guideposts,” explicit targets for wage settlements and price increases. Kennedy and his advisors consulted directly with industry and unions – and it was the heyday of unions – during negotiations. His showdown with Steel is notable. The steel unions agreed to a contract within the targets, and virtually the next day all but one of the top steel companies announced price hikes well above the targets. Kennedy is reported to have said, “My father told me that businessmen were sons of bitches, but I didn’t believe it until now.” The coordinated response from his administration was equally volcanic. Investigations were launched by several departments. Contracts were withdrawn and given to Republic Steel, the lone dissenter from the price rise. Every other mechanism was employed. Steel backed down.
Lyndon Johnson during the guns and butter inflation of the late 1960s imposed a ten percent income tax surcharge to take spending power out of the economy. He was the last president to make a tax hike a central point of his economic policy.
Richard Nixon’s was probably the most dramatic. The wage-price freeze. At the same Camp David retreat that produced the decision to go off the gold standard and let the dollar float, the Nixon brain trust came up with a freeze on wages and prices to dampen inflation. Evasion of the controls, including simple cheating, caused them eventually to be abandoned. Their removal witnessed an unexpectedly sharp increase in prices and some time later Nixon, against the advice of his advisers this time, reimposed them. They were even less effective the second time.
Gerald Ford and his chief economist Alan Greenspan tried out the WIN button – Whip Inflation Now – a call for citizen action that never came.
Jimmy Carter put the brakes on gasoline consumption with the 55 mile per hour speed limit and employed Alfred Kahn’s deregulation theories in an effort to reduce business costs. It had some success, but also some notable failures. The 55 mile per hour speed limit may have been the last sacrifice asked of the American consumer, so unpopular did it prove to be.
Then came Ronald Reagan. Reagonomics borrowed deregulation from Carter, but it was for deregulation’s sake. His approach to inflation was to walk away from it and let the Fed handle it, first Paul Volcker, then Alan Greenspan.
The Reagan-Volcker Recession of 1981 was fomented by double-digit interest rates. At that time, it was the supply of money that was restricted, and interest rates were allowed to find their own level. The major inflation fighters during those years were the long lines of unemployed workers and the manufacturing industries that lost out to the high interest high deficit high dollar.
Since then, only the contraction of growth in government under Clinton can be seen as anything approaching a fiscal remedy for inflation. In Clinton’s final year in office, the strategic petroleum reserves were tapped to keep oil prices down, but it was more a favor to Al Gore’s campaign for president than anything else.
So there are non-monetary remedies for inflation that have been tried. Some have been successful.
A couple of notes. In our forecast recap Monday, we missed repeating our call that the Fed will overreact to inflation pressure. We’ve put up some charts on the blog: Demand Side Blog or demandsideblog one word dot blogspot dot com to show you what we think the Fed is looking at and why they might get spooked.
We have called for a cost-push inflation from the rising prices of imports, commodities and the bidding up of domestic products with export markets.
The charts, if you look closely, core consumer inflation simply lags the headline inflation, as higher prices are embedded in costs. Notice the trend of both follows oil prices. Oil isn’t as big per unit of GDP as it used to be, but neither is anything else, including an hour of labor.
We chart producer prices and consumer prices. The PPI, producer price index, has recently risen above the consumer price line, which might cause consternation. Particularly if you look at 1999, when it also happened. Shortly afterward Alan Greenspan began ratcheting up interest rates, right into the rising oil prices that caused the spike to begin with. The result – in our view – contributed to the so-called dot.com bust. It happened again briefly at the beginning of 2005, and we suspect encouraged the last rate hikes.
The third chart takes at look at headline PPI v. core PPI. The latest readings – November – in headline producer prices are the highest in twenty-five years.
The final chart is headline versus core personal consumption expenditures. Just again to note that one leads the other, and a caution to officials not to panic. Or to get too grandiose.
“In all but the shortest of terms, it is the Federal Reserve’s policy that determines how much inflation there is, and we’re going to make sure that the inflationary impact that may come from the weakening dollar is not passed into broader prices and become part of the underlying inflation rate.”
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