The road to zero inflation - A Review of Federal Reserve Policy

Business Economics, July, 1991 by Lyle E. Gramley

This article discusses whether a 4 to 5 percent inflation rate should be accepted or brought lower. Price stability cannot be achieved without some loss of employment and real output. Thus far the current Federal Reserve has expressed a belief in long-run price stability. However, the real test will be whether the Federal Reserve will refocus its policies on the long-run objective of price stability once the economy turns the corner from recession to recovery.

FOR MORE THAN A DECADE, the Federal Reserve has had as its top priority the achievement of an inflation-free economy. That goal has proved to be elusive. The inflation rate declined substantially from 1980 through 1982, when the economy went through two recessions, the second of which was the longest and deepest of the postwar period. Since then, the inflation rate has hovered between 4 and 5 percent.

Today's 4 to 5 percent inflation rate looks good compared to the double-digit figures of the late 1970s (See Chart 1). However, the current inflation rate is approximately equal to the average for the entire period since the end of World War 11, and well above the typical rate prevailing during the first twenty-five years of the postwar period.

When Paul Volcker left his post as Chairman of the Federal Reserve Board in 1987, he was a national hero because of what the Federal Reserve (Fed) had accomplished during his stewardship. At the time, there was concern that his successor, Alan Greenspan, might not be as dedicated to reducing inflation as Volcker had been. That issue is not fully settled, but the Greenspan Fed has been tougher on inflation than the Bush Administration would have liked. Indeed, officials of the Bush Administration grumbled loudly last year about the limited and gradual response of the Federal Reserve's monetary policy to the slower economic growth that developed in the first half year, and the recession that followed the Iraqi invasion of Kuwait in August.

Politicians are typically reluctant to support strong anti-inflationary policies while they are in office, especially in an election year. Perhaps the carping that was heard about timid monetary policies in 1990 can be explained on those grounds alone. I suspect, however, that the problem goes deeper - that some people, at least, are getting weary of a decade-long fight against inflation that has been less than fully successfully.

Should we accept 4 to 5 percent inflation as the best that can be done, or at least as a practical goal? Chairman Greenspan and many of his colleagues at the Federal Reserve System apparently do not think so. They have strongly supported a bill introduced by Congressman Stephen Neal (Democrat, North Carolina) to establish price stability as the long-run goal of Federal Reserve policy. As Greenspan has indicated, price stability does not mean literally zero inflation, but an inflation rate so low that it no longer enters as a significant factor in economic decision-making. In the early 1960s, for example, the inflation rate was between 1 and 2 percent, and that would very likely satisfy Greenspan's criterion.

Will the Federal Reserve persist in its efforts to bring down inflation? If so, what will be required to reach the objective of price stability? These are not easy questions to answer. History suggests, however, that the road to zero inflation may be long and bumpy.

INFLATION IN SERVICES

Let me begin by knocking down what I believe is a straw man. It is sometimes argued that one barrier to the achievement of price stability is the failure of competition to work effectively in markets for services. For many of the goods that consumers buy, competition is fierce, because domestic producers face the threat of losing market share to imported goods if they do not produce and sell high-quality products at competitive prices. Over half of what we as consumers buy, however, consists of services, not goods.

During the year ended March 1991, prices of all consumer items rose 4.9 percent. Prices of commodities, which make up 45 percent of the Consumer Price Index (CPI) rose 3.8 percent, while prices of services (55 percent of the CPI) increased 5.8 percent. A particularly bad actor in the service area was medical services, whose prices increased 9.7 percent. Within the medical services component, the rise in hospital costs has been accelerating during the past five years.

There are probably few, if any, sectors of the economy in which competition works less effectively to hold down the rise of costs and prices than in hospital services. Nonetheless, competition probably also works poorly in such areas as public transportation services and educational services, whose prices are rising considerably faster than the overall rate of consumer inflation.

Inflation control would certainly be easier if competition worked better in the service industries, but that is not the main obstacle to the achievement of price stability. In the long sweep of history, the inflation rate for consumer services generally tends to move in the same direction as the rate of price change for commodities, as indicated in Chart 2. On average over the past three decades, prices of consumer services have increased about 1 1/2 to 1 3/4 percentage points faster than prices of consumer commodities.