Understanding inflation: lessons from my central banking career; the main lesson is that inflation is still a mystery

Business Economics, Jan, 2003 by Harvey Rosenblum

A New Economy?

To a Shumpeterian economist like myself, who believes in the renewal powers of creative destruction, the idea of a "new economy" seems like a truism. As noted by Robert Samuelson (2002), "the economy is constantly recreating itself. It is always 'new,' if 'new' means different from the past." Yet, around 1997 I was talking publicly about the economy being "new and different," not just different.

Let me add some context. As I've mentioned, I have spent a long career with the Fed and the central theme of my career has been understanding inflation, taming inflation, and helping to bring in and maintain an era of price stability before I retire. Something happened during the 1990s to inflation that was not just different from the prior twenty-five years; it was markedly different. A confluence of inflation-depressing forces, each with a half life of five-to-seven years, and perhaps longer, converged on the U.S. economy in the 1990s. Inflation subsided when our economic models said it should have risen. To a central banker whose focus had been on inflation the prior twenty-five years, this was a sufficiently different and potentially long-lived experience to be labeled "new." This had the potential to accelerate my retirement, not because my investments were doing well, but because my inflation goals were being met ahead of schedule and my leadership legacy could be in place faster than anticipated.

When I studied economics in school, I read about cost-push inflation. In my speeches now, I routinely use the term "cost-compression disinflation." I studied about a wage-price spiral and prices and wages moving in only one direction, up, never down. We have two-way price and wage flexibility today: in my lifetime this is "new."

Earlier, I mentioned that I'm a micro guy in a macro world. Consequently, my views on the new economy focus on the environment in which microeconomic decisions are made. To me, the essence of the "new economy" is that when businesses are confronted with rising costs, their impulse is to boost productivity, not prices. Unlike the 1960s and 1970s, there is an economic imperative to boost productivity: raising prices is a last resort. This is fundamentally different. The competitive climate makes raising prices considerably more difficult today than it was three decades ago. These conditions won't last forever, and I have already alluded to ways in which the economic climate is changing since September 11, 2001.

I am not alone in my beliefs about a new economy and the prospect that it will be with us for several years. Former CEA Chairman Martin Baily (2002), who has addressed NABE several times in recent years, defines the driving force behind the new, or different, economy of the 1990s much as I have done. His findings suggest that the main driver of productivity acceleration was increased competitive pressures that forced improvements in business operations. He adds that the 1990s economy "experienced heightened competition in an increasingly deregulated economy with strong international competition." Firms across a wide range of industries sought out new technologies, not because they wanted to, but to repeat a term I used earlier, because they had no other choice. Baily projects that these competitive driving forces will be around for several years.