What we have now is an unannounced and almost unconscious policy to eliminate inflation in fits and starts. This is one cause of today’s faltering economic recovery, whose fragility was underlined by last week’s sharp stock-market decline. Unlike the 1960s and 1970s, the Federal Reserve is serious about moving toward price stability. But the Fed’s new caution, coupled with consumer and business pessimism, is hobbling the recovery.
Price stability is worth having. Its loss was a great economic calamity of the postwar era. The alleged benefits of modest inflation–lower unemployment and faster economic growth–were illusory. In the 1950s, unemployment averaged 4.4 percent; in the 1970s, it was 6.1 percent. Inflation has also favored speculation over productive investment. And, finally, inflation has fostered many other problems: the savings and loan debacle, for instance. When inflation raised short-term deposit rates, S&Ls suffered huge losses on fixed-rate mortgages made at lower rates; these losses started the industry’s downward spiral.
Each recession now gives the Fed a chance to reduce inflation a bit more. Look what’s happening. The severe 1981-82 recession reduced it from double-digit levels to a 4 to 6 percent range. It’s now dropping to a 3 to 4 percent range. (In the past year, consumer prices have risen 2.9 percent, down from 6.1 percent in 1990; for 1992, most economists expect inflation of about 3.5 percent.) Slumps later in the decade could cut it to 1 to 2 percent annually.
As a practical matter, that would be price stability. Price increases would be so small, as Fed chairman Alan Greenspan has said, that they wouldn’t affect everyday decisions by businesses or consumers.
But this lurching toward price stability is–as we are being reminded daily–an enormously bruising and uncertain process. People and institutions who bet on inflation are big losers. A decade ago, farm loans made on the basis of rising crop prices and land values couldn’t be repaid. A bushel of soybeans fetched $7.60 in 1980 and $5.71 two years later; an acre of Iowa farmland fell from $1,999 in 1981 to $786 in 1987. Commercial real-estate developers and their bankers are now suffering the same fate. Loans premised on perpetually rising prices for buildings are going into default by the thousands.
The other big problem is that any shift to lower inflation depresses the economy’s growth temporarily. It takes time for wages, prices and interest rates to adjust to lower levels. This effect has clearly helped subvert the current recovery.
Consider the case of long-term mortgage interest rates. They’ve declined much less than short-term rates. Since mid-1990, the Fed funds rate (a short-term rate directly influenced by the Federal Reserve) has dropped from 8.5 percent to 4.75 percent. But rates on 30-year fixed mortgages have fallen only from 10 percent to 8.75 percent. Mortgage rates reflect the long-term outlook for inflation; they don’t come down until lenders feel confident that future inflation will be lower.
The result is a Catch-22: the recovery requires lower long-term interest rates; but these rates decline only after poor economic growth–which reduces price and wage increases–convinces lenders that inflation is subsiding. Because the adjustment is slow, the housing rebound has sputtered. For the same reason, mortgage refinancings–borrowers converting to lower-rate loans–have only recently increased. In 1991, refinancings could now total $132 billion, according to the Federal National Mortgage Association. This should ultimately help consumer spending by reducing homeowners’ debt burdens.
The temporary costs of reducing inflation–high unemployment, lost production, increased anxiety–limit how forcefully the Fed can move. After all recessions, it faces the same dilemma: sustaining recovery without squandering gains against inflation. Holding short-term interest rates too high could plunge the economy back into recession. Lowering them too much might repeat the mistakes of the 1960s and 1970s: the recovery would raise inflation. The idea then was that unemployment could be permanently lowered by accepting a bit more inflation.
The difference now is that this old inflationary bias has been muted. Price stability is openly discussed as a serious goal. “Our money should be … a lasting standard of value,” says governor Wayne Angell of the Federal Reserve Board. Fifteen years ago, this kind of talk was almost never heard. To many critics of the Fed, paying too much attention to inflation now is a tactical mistake. It risks a double-dip recession. Maybe. Even Fed officials admit that the economy is weaker than expected and that cuts in short-term rates haven’t yet had their predicted tonic effect. But people who favor price stability–people like me–also worry that the Fed’s anti-inflation resolve will wane.
There are always pressures, especially in an election year, to speed up the economy. By contrast, price stability seems an abstract goal. No one favors double-digit inflation, but why is it important to get down from 4 percent? The answer is trust. A government that can run 4 percent inflation can easily let it slip to 5 or 6 percent (as we did between 1987 and 1990). The commitment to price stability, a more believable standard, is a defense against that.
An economy without inflation will tend to be more productive and will inoculate itself against the effects of high–and rising–inflation on public confidence. The difficulty of restoring price stability only emphasizes the huge irresponsibility of ever relinquishing it. That mistake launched us on a hard odyssey that has lasted decades and, with luck, will one day bring us back to where we started.
