SYNOPSIS:

The Fed Focuses On Prices. Factory orders dropped by 1.4 percent in June and consumer spending inched up by just 0.5 percent during the same period, but most economists still believe that the Federal Reserve Board's policy of reducing interest rates has ended the 1990-91 recession. With the struggle against recession apparently over, attention will now shift to another topic that has long preoccupied the Fed: what to do about inflation.

Eleven years ago, when consumer prices were rising at a 13 percent annual rate, inflation fighting was a top priority for America's monetary officials. By 1983, the tight-money policies of then Fed Chairman Paul Volcker had reduced the annual inflation rate to less than 4 percent. Since that time, the central bank has been content with average price increases of about 4 percent a year. But some influential members of the Fed and some conservative politicians would like to snuff out inflation altogether. They point out that while prices are rising more slowly now than they were 10 years ago, at the current rate of inflation the cost of living will still double over the next two decades. A zero-inflation policy sounds very appealing. But, because the short-run costs massively outweigh the putative benefits, the United States will never experience true price stability.

First of all, reducing the current 4 percent inflation rate would yield very small economic gains. Mild inflation raises consumer prices slightly, but it also raises personal incomes. Price instability can make it difficult for businesses to plan for the future, and it can distort tax collection. But these costs are unlikely to be a burden unless the inflation rate soars into double digits. The present inflation rate in the United States probably results in costs that are only a fraction of 1 percent of the gross national product.

Growth With Inflation. International experience also shows that mild inflation does not retard economic growth. Over the past 30 years, for example, France has had an average inflation rate of 7 percent, twice as high as Germany's. Yet per capita GNP has grown slightly faster in France than in Germany: 3.0 versus 2.7 percent. This doesn't mean that inflation was a good thing for the French economy; but if it did any harm, the damage was too small to detect.

History further reveals how costly inflation reduction can be. To curb price increases in the late 1970s and early 1980s, Paul Volcker's Fed raised interest rates above 20 percent. These stratospheric rates ultimately brought inflation down to earth, but only after precipitating painful recessions in 1979-80 and 1981-82. Before Volcker's anti-inflation policy kicked in, the unemployment rate in America stood at 5.8 percent; by the end of the second recession, unemployment was up to 10.7 percent. And joblessness did not drop back below 6 percent (its historical average) until 1987. The total cost of this abnormally high unemployment and the idle capacity it bred has been estimated by most analysts at more than a trillion dollars.

An effort to drive inflation from 4 to 0 percent could be almost as expensive. For supporting evidence, one need only look at Canada. For the past two years, the Bank of Canada, the Fed's counterpart, has zealously tried to eliminate inflation. The result so far is small price increases, but a big recession. Since 1989, Canada's unemployment rate has risen from 7.5 percent to 10.5 percent.

The High Cost Of Zero Inflation. To achieve zero inflation, the Fed would probably have to engineer a recession that would keep the average rate of unemployment at 7.5 percent for the next five years. During this period, joblessness would peak at 9 percent or more. Clearly, this makes very little sense. Americans have learned to live with modest inflation; and gradual price increases do not represent a major economic threat. Achieving true price stability is an alluring goal, but millions of citizens will not suffer in order to attain it.

Mild price increases

The Federal Reserve sharply reduced inflation in the early 1980s, and, as a result, prices have risen slowly.

U.S. consumer price inflation

1978 7.6 pct.

1979 11.3 pct.

1980 13.5 pct.

1981 10.3 pct.

1982 6.2 pct.

1983 3.2 pct.

1984 4.3 pct.

1985 3.6 pct.

1986 1.9 pct.

1987 3.6 pct.

1988 4.1 pct.

1989 4.8 pct.

1990 5.4 pct.

1991 4.7 pct.

Nagging unemployment

Lower inflation in the United States has meant slower growth and relatively high unemployment.

U.S. unemployment rate

1978 6.1 pct.

1979 5.8 pct.

1980 7.1 pct.

1981 7.6 pct.

1982 9.7 pct.

1983 9.6 pct.

1984 7.5 pct.

1985 7.2 pct.

1986 7.0 pct.

1987 6.2 pct.

1988 5.5 pct.

1989 5.3 pct.

1990 5.5 pct.

1991 6.7 pct.

Painful recession

Canada's attempt to totally eliminate inflation has led to dramatic job losses and a severe recession.

Quarterly unemployment rate

U.S. Canada

1989

1 5.1 pct. 7.5 pct.

2 5.2 pct. 7.7 pct.

3 5.2 pct. 7.5 pct.

4 5.2 pct. 7.5 pct.

1990

1 5.3 pct. 7.5 pct.

2 5.3 pct. 7.5 pct.

3 5.6 pct. 8.3 pct.

4 5.9 pct. 9.1 pct.

1991

1 6.5 pct. 10.1 pct.

2 6.8 pct. 10.3 pct.

Note: Figure for 1991 inflation reflects June-June period; unemployment figure is for first half of 1991.

Originally published, 8.12.91