What, Me Worry About Inflation?

Sanjay Paul

A version of this article appeared as in August 1996, Business Forum, Green Bay Press- Gazette.

Recently released data show that the consumer price index, a commonly-used measure of prices in the economy, rose by 0.3% in July. Since this was slightly higher than analysts had expected, the financial markets faltered on the news.

Is inflation about to rear its ugly head?

The ingredients for rising inflation seem to be in place. Following a modest rise in the first quarter, the economy's output of goods and services has grown by a more robust 4.2% in the second quarter. The quickening pace of economic growth has been accompanied by a fall in unemployment - at around 5.5%, the current unemployment rate is remarkably low.

That's good news, isn't it? Well, yes and no. Low unemployment means more jobs. Factories running close to capacity. Workers able to land jobs quickly.

And firms begin to scramble to find suitably skilled workers. Therein lies the problem.

As the economy's output nears its potential level - the maximum output that can be produced without a resurgence in inflationary pressures - employers find it increasingly difficult to hire and retain qualified workers. Accordingly, firms are forced to fatten their employees' pay packets. As firms try to recoup the increase in the cost of production by charging higher prices for their goods and services, we have - presto! - the dreaded surge in inflation.

This is why market analysts keep a wary eye on the statistics pertaining to employment, wages and economic growth. For, if the data suggest a pickup in economic activity, fears of inflation begin to mount. This is accompanied by an apprehension that the Federal Reserve will raise interest rates to choke off incipient inflationary pressures. The result: declines in the stock market and bond market.

Is this pessimism justified? That is, must sturdy economic growth be accompanied by the specter of higher inflation?

Let's look at the performance of the U.S. economy during the last four years. In that period, the economic output has risen steadily along with a corresponding decline in unemployment. Remarkably, inflation too has fallen. Despite several months of low levels of unemployment, inflation has been subdued. No big wage increases, no significant rise in prices.

How come?

Couple of reasons. One, increasing competition from foreign firms prevents domestic firms from raising prices too quickly.

The second reason for the continued check on inflation is the rising productivity of the U.S. labor force. As workers become more productive, their wages will increase; yet, since companies reap the fruits of higher productivity in the form of increased output, they may not raise prices. Especially when they face fiercely competitive pressures from foreign firms.

There is a third factor. Recent research done by Mike Mauthe and me suggests that the price of oil may play an important role in determining inflation. Sustained increases in the price of oil, such as those that occurred during the 1970s, are likely to result in higher inflation. In the past four years, the price of oil has not witnessed such increases. Nor is there any compelling reason to believe it will rise sharply in the near future. Unless, of course, something untoward occurs in the Middle East....

What do we conclude from the July figures then? Is a steep rise in inflation just around the corner? Noting the continued presence of foreign competition, rising labor productivity, and the likelihood of fairly stable oil prices, the answer is No.

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