A half-year pause in inflation: its antecedents and structure - Consumer price index suggests lowest inflation rate in 20 years

Monthly Labor Review, Oct, 1986 by John F. Early, Walter Lane, Philip Sturm

A half-year pause in inflation: its antecedents and structure

Inflation as measured by the Consumer Price Index for all Urban Consumers (CPI-U) declined at a seasonally adjusted annual rate of 0.2 percent during the first 6 months of 1986. While a continuation of this pattern is unlikely throughout the remainder of the year, the resulting change for 1986 will probably be the smallest annual increase since the first half of the 1960's.1

The first-half decline reflected the sharp drop in crude oil prices, as the index for energy commodities--fuel oil, coal, bottled gas, and motor fuels fell at an annual rate of 40.2 percent in the first half of 1986. Prices for used cars and grocery store foods also declined in the first half. On the other hand, shelter costs continued to advance at an annual rate of about 5 percent. The index for all items excluding food, shelter, energy, and used cars increased at an annual rate of 4 percent during the first 6 months. Within this group, however, price movements for commodities and for services continued to diverge. Price increases in the goods sector moderated further, but prices for services, in particular medical care, accelerated. (See table 1.)

Background 1960 to 1981

The early 1960's were characterized by rapid economic expansion, with prices increasing at an annual rate of 1.3 percent for the 5-year period which ended in December 1965. (See chart 1.) Price pressures developed in the late 1960's, however, as expenditures for the Vietnam War stimulated an economy already at nearly full employment. The rate of inflation in consumer prices rose from less than 2 percent in 1965 to more than 6 percent in 1969.

From chart 2, one can identify the general composition of price change in each of these periods. The top line displays the average annual rate of change for the all-items CPI-U during the periods identified on the horizontal axis. This seasonally adjusted overall inflation rate can be constructed as the sum of the individual contributions of four major classes of consumer expenditures--energy, food, shelter, and all other--as follows:

From the chart, one can see that the acceleration in prices from the first half to the second half of the 1960's was widespread, except that energy prices had very little impact.

The recession which began late in 1969 caused the rate of price increase to subside only partially, and much of that reduction was due to the effect of declining mortgage interest rates on the shelter component of the CPI. In reaction to the failure of inflation to abate swiftly and fully, President Nixon announced a wage and price freeze on August 15, 1971. The initial price freeze and subsequent Phase II economic controls were accompanied by a lower rate of inflation during the final months of 1971 and throughout 1972. Prices, however, started to rise more quickly in 1973, and further inflation followed with the relaxation of controls in August and the oil embargo in October. Although the direct effects of the oil embargo on inflation were substantial, they were far from unique. Sharply higher mortgage interest rates and house prices drove up shelter costs; food prices, influenced in part by worldwide commodity inflation, rose rapidly; and prices for most other goods and services began to accelerate.

Inflation climbed to double-digit rates during 1974 and registered what was then the largest calendar year change in the history of the CPI, except for the inflationary periods directly associated with the two World Wars. With the steep recession of 1973-75, inflation moderated substantially so that, by the end of 1976, consumer prices were rising at an annual rate of less than 5 percent. With the economic expansion in 1977, prices began to accelerate. Then sharp increases in energy prices were fueled by events associated with the Iranian crisis, and rapid price rises for food and shelter costs followed, pushing consumer price rises to unprecedented peacetime rates during 1979, 1980, and, indeed, for most of 1981.

Deceleration since 1981

Two back-to-back recessions (1980 and 1981-82), a tight monetary policy, and lessened control by OPEC of world petroleum supplies all contributed to a rapid reduction in the rate of inflation beginning in the fourth quarter of 1981. This moderation in prices brought an end to the "ratchet phenomenon' that had characterized inflation since 1960. Before 1981, each succeeding low point in inflation was higher than the preceding low, and each high point was also higher than the preceding high. (See chart 1.) The 3.9-percent price increase for 1982 was the smallest annual increase in 10 years.

The price deceleration that occurred in the 57 months through June 1986 was particularly apparent in the energy, shelter, and food components of the CPI. (See charts 2 and 3.) Advances in these items had, of course, been responsible for much of the increase in the CPI in the past decade. Unlike earlier episodes, however, the index excluding the energy, shelter, and food components also moderated substantially, rising at a 4.8-percent seasonally adjusted annual rate during the 57 months through June 1986, compared with a 9.6-percent increase for the 12 months ended in September 1981. Chart 3 provides more detail than chart 2 on the post-1981 period. The data are as follows: