Inflation's Painful Slowdown

By George L Church

Recession brings welcome relief from a decade of surging prices

Whatever else it may be remembered for, the presidency of Ronald Reagan has already been firmly linked with one happy economic achievement: the start of the wind-down of the longest sustained inflationary surge in the nation's history. A year ago, the woozy U.S. economy was wobbling atop a seemingly endless inflationary spiral, traumatizing families everywhere with the vision of a lifetime of work and savings being eroded to nothing by the whirlwind of runaway prices.

Yet the specter of double-digit inflation is fading fast. Indeed, the Consumer Price Index., which was bounding up at a 14% annual rate as recently as last September, rose at a mere 3.7% pace in January. Economists now freely predict that the February figure, to be announced this week, will show an equal or even more modest increase. A few are timidly speculating that it might actually drop for the first time in 16 years.

Three indexes of producer (wholesale) prices--for finished goods, partly processed materials and raw commodities--really did fall in February, the first time that all went down simultaneously since February 1975. Moreover, the slowdown has been going on long enough that it cannot be dismissed as a fluke. The Producer Price Index for finished goods, those ready to be stocked on store shelves, has been declining fairly steadily and significantly since January 1981.

Best of all, many economists, including some who have very little sympathy for Reagan's economic policies, think that these gains are not just a temporary result of the current economic slump. They see signs that the inflationary cycle of the 1970s may really have been broken--although it took an exceptionally severe recession to finish it off. The drop in inflation, says Walter Heller, chairman of the Council of Economic Advisers under Presidents Kennedy and Johnson, "is in good part a fundamental change, a structural change." Adds Otto Eckstein, a member of TIME's Board of Economists: "Sure, if the economy picks up, there might be some acceleration in inflation, but it should not be anywhere near double-digit levels. Barring any new disaster in the world, I think we have eliminated double-digit inflation."

Yet these prospects have prompted curiously little celebration. Headlines about the decline in inflation have been modest, and often displayed on financial rather than front pages. Even the Administration, which made reducing inflation its top priority, is blowing only a muted self-congratulatory trumpet. The President complained rather mildly last week that the heartening price developments "haven't quite got all the attention that they deserve." He is correct, and although Reagan has refrained from taking credit for the drop in inflation, as well as from accepting blame for the recession that has helped to cause it, both have occurred while he has been in charge.

One reason for the lack of jubilation is fresh memories of previous false starts in beating inflation. Most notably, as a result of the last deep recession, the inflation rate as measured by the CPI tumbled from 12.2% in 1974 to 4.8% in 1976--only to roar back up to a postwar peak of 13.3% in 1979. And while there is good reason to believe that the gains this time may be more lasting, the cost has proved to be fully as painful as everyone was predicting a year or so ago.

Recessions almost always drive down inflation because prices cannot be raised rapidly when production and sales are falling. As business activity winds down, stockpiles of unsold commodities and goods begin to swell, choking the stream of commerce with bulging inventories of everything from aluminum and grain to cars and unsold homes. To raise cash, businessmen begin dumping their inventories at bargain-basement rates, dragging down prices even further.

Thus as the current recession has gathered momentum, many a family has suddenly discovered itself a potential casualty in the very inflation fight that people pressed Washington to undertake in the first place. Instead of fretting over the perils of runaway prices, workers everywhere now agonize over losing their jobs. A New York Times/CBS News poll published last week found that 32% of those questioned regarded unemployment as the most serious problem currently facing the country, vs. only 15% who saw inflation as the No. 1 villain. Even so, the public commitment to battling inflation remains astonishingly high. In the same poll, respondents voted 53% to 32% to cancel the 10% cut in income tax rates already enacted to take effect July 1 if that should be necessary to reduce the gargantuan budget deficits that might reignite inflation on the upswing out of the slump.

Lately some signs have appeared that the recession may at long last be starting to bottom out. Industrial production rose 1.6% in February, after six months of deep decline. Housing starts also went up a bit during the month, though still remaining at a severely depressed level.

Such signals are hardly conclusive; in part they represent nothing more than a rebound from January's extraordinarily depressed production levels, which were brought on by a monthlong cold snap across much of the nation. Moreover, several major banks last week raised their prime interest rate on business loans back up to 16 1/2%, canceling the half-point drop of a week earlier and reinforcing a winter-long level of sky-high interest charges that could all too easily abort an early recovery from recession, or keep the rebound weak when it does begin.

Looming over all weekly statistical gyrations is the far larger and more important question of what will happen to price trends once the economy does indeed begin to grow again. No one can be sure, yet this time the recession has not interrupted a boom but has come after three years of virtually zero growth in the economy. The long suppression of demand may finally have broken or even reversed the trends that kept prices shooting up throughout the 1970s--some of which may have been burning themselves out anyway.

The most startling and significant example of this change in underlying trends is the price of oil. Nothing did more to propel inflation ever higher during the 1970s than the success of the Organization of Petroleum Exporting Countries in raising the benchmark price of a barrel of crude from $1.80 in 1970 to $34 now. Besides the skyrocketing increases in retail prices of gasoline, the spiral helped drive up everything from apartment rents, which are affected by fuel costs, to the price of food, which is hauled to supermarkets in diesel-burning trucks.

Eventually, however, the petro-price spiral reached the point at which consumers and industry worldwide simply would not, or even could not, pay any more. Prompted by recession, they cut back on usage so sharply that the world is now awash in surplus oil, and prices are coming down. When lines form at gasoline stations these days, it is not because of shortages but because prices have dropped--below $1 per gal. in Texas.

In a desperate attempt to halt the drop in prices, members of OPEC gathered in Vienna over the weekend and announced an agreement for a modest production cut of 200,000 bbl. a day to 18 million bbl. a day. It is the first time the members have agreed jointly to curtail output in order to stabilize prices. Nevertheless, a number of OPEC states are already badly in need of cash, and will be sorely tempted to increase production in the weeks and months ahead.

Oil is only one of many vital commodities that underwent spectacular price increases in the 1970s. But slow growth, and now recession, has burst the bubble in one raw material after another. Copper prices, for example, have plunged to 76-c- per lb. from 89-c- a year ago, badly burning unlucky speculators in the process.

Rising food prices have also been a prime source of inflationary pain and despair over much of the past decade. But food prices last year rose only 4.3%, less than half the 10.1% jump in 1980. Many economists predict that the increase this year will be only slightly larger, perhaps 5% or so.

In part, the slowdown is the result of luck with the weather, which has produced bin-busting crops for several years. In the 1970s, food prices often kept right on rising rapidly even when crops were huge, but that is no longer happening. Export demand has somewhat abated as good crops in many nations have bolstered world supplies. Meanwhile, high interest rates have made it prohibitively expensive for farmers to maintain large storage operations, and as food has been pushed onto the market, prices have slumped. Finally, says Gene Sullivan, director of regional economics at the Federal Reserve Bank of Atlanta, after years of having their incomes pinched by inflation and now recession, "consumers are more price discriminatory. They are not purchasing beefsteak whatever the price."

Inventory liquidations by businessmen are simply accelerating the downward price pressure. The most striking examples, of course, are in the auto industry, which is now offering rebates of up to $2,000 on some cars to help move the vehicles off dealer lots. But businessmen of all sorts have begun pruning stocks. Stevan Buxbaum, who runs a Los Angeles discount clothing store called Ideal Fashions, reports that manufacturers are calling him from as far away as New York City and offering clothes at prices below wholesale just to move the garments out of their plants.

Production cutbacks will sooner or later bring an end to the liquidations, and thus no economists are forecasting that inflation rates will stay as low as they now are. The Reagan Administration's own official forecast sees the CPI rising by 7.3%. this year, vs. an 8.9% increase in 1981 and a 12.4% rise in 1980. That forecast not long ago looked optimistic, but now is at the upper end of the range of predictions being put forward by private economists.

Whether inflation can be kept from marching right back up again in future years of recovery depends heavily on what happens to wages. In the long run, most economists think, prices tend to rise at about the rate by which labor costs exceed productivity gains, although special factors, such as wild fluctuations in oil, food and housing prices, can cause actual inflation to run either above or below this so-called core rate for long periods. For the past several years, most economists figured that the core rate was stuck at 9% to 10%, kept there by a fruitless scramble among workers to jack up their pay in order to catch up with past inflation. Now nearly all economists agree that the core rate is coming down, and is at present probably about 7 1/2% to 8%.

So far in 1982, the Teamsters Union has signed a contract with major trucking firms providing for reduced benefits and no wage increases, and the United Auto Workers has agreed with the Ford Motor Co. on a contract containing wage and other concessions calculated to save the company $1 billion in labor costs over the 31-month life of the contract. U.A.W. and General Motors bargainers last week sat down to work out a similar deal that both sides hoped to have ratified by the union rank and file next week. On the other hand, economists are by no means sure that labor will continue to be so docile if unemployment stabilizes and workers are no longer fearful about losing their jobs.

Probably the biggest question hanging over the future course of prices is the policy of the Federal Reserve Board. During the 1970s, the Federal Reserve kept the money supply growing at a pace that aggravated inflationary trends. But after Paul Volcker became chairman in 1979, he slowed the growth of money so sharply that interest rates eventually shot to near record highs even as the economy tipped into recession. Strong doubts persist, however, that Volcker will continue that course if the economy drops much further. Says Alan Greenspan, a non-Government adviser to President Reagan: "The financial markets are saying essentially that the Fed will in the end accommodate the budget deficits with a substantial growth in the money supply, thus abruptly putting an end to the softening in inflation." Volcker has repeatedly vowed that the Federal Reserve will do no such thing. But if he keeps money tight, Government borrowing to cover the deficits could drive interest rates still higher, thus prolonging and deepening the recession.

In fact, the best and perhaps only way for the U.S. to enjoy a noninflationary recovery would be to whack down the deficit, thereby reducing borrowing pressure and permitting interest rates to drop. Reagan in recent weeks has been hearing pleas to lower the deficit--perhaps by cutting defense spending, perhaps by reducing or delaying tax cuts--from conservative supporters in such organizations as the Business Roundtable and the National Association of Manufacturers. So far the advice seems only to annoy the President. In a speech to the N.A.M. last week, he declared, "I've been a little disappointed lately with some in the business community who have forgotten that feeding more dollars to Government [by increasing taxes] is like feeding a stray pup. It just follows you home and sits on your doorstep asking for more."

The U.S. has long known that a recession will curb price increases temporarily; it is now learning that a deep enough recession can even begin to turn around deep-seated inflationary forces. But the nation is a long way yet from proving that it knows how to combine low inflation with sturdy growth in production, incomes and jobs.

--By George L Church. Reported by Bernard Baumohl/New York and Gisela Bolte/Washington

With reporting by Bernard Baumohl, Gisela Bolte

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