It is sometimes said the generals inevitably fight the last war. That notion seems applicable both to the Federal Reserve and to those who prognosticate about the next Fed decision on interest rates. Each time the Consumer Price Index is released, Fed watchers speculate on whether the inflation news will, or will not, trigger a rise in rates. And, although detailed transcripts of the Fed's Open Market Committee's meetings are available only with a six year lag, it is apparent from reading them that Fed policymakers also scrutinize the CPI's entrails to see if future inflation is threatening. They become particularly anxious that workers will "demand" wage increases if the unemployment rate drops too low, thus pushing up costs and prices. If an uptick in inflation is perceived by the Fed, interest rates are shoved up to slow the "overheated" economy.
The last war in the case of the Fed was in the 1970s and early 1980s the era of so-called "stagflation" when inflation and a sluggish economy managed to co-exist. In that era, and indeed in the period from the end of World War II until the painful dis-inflation under Ronald Reagan, the economy was quite different from what exists today. Two principles developed during the age of stagflation that still condition Fed decisions. The first was that the economy is inherently inflation-prone so that it's best to be prudent and squash even the hint of inflation quickly. The second principle was that once inflation begins, it is very difficult to reverse it. Both ideas were true in the past. But are they true today?
With a colleague at
UCLA, I have been doing research on anti-inflation policy from Truman through Carter. There was much fretting about inflation over that 35-year period. Mandatory wage-price controls were imposed twice, once during the Korean War under Truman and
again during the Vietnam War under Nixon. "Voluntary" wage-price guideposts were also imposed twice, once under Kennedy and Johnson and again under Jimmy Carter. Although no formal controls or guideposts operated under Eisenhower and Ford, both of those administrations periodically exhorted business and labor to moderate their wage and price decisions and act responsibly. Clearly, policymakers back then believed that a few union leaders and a few company CEOs made wage and price decisions that set a pattern for the entire economy.
Days of steel
Tape recordings now available at the John F. Kennedy Presidential Library of Oval Office conversations are especially revealing. The president spent endless hours discussing conversations held on his orders between top administration officials and representatives of "big labor" and "big business" about union wage settlements and company pricing decisions. Of particular concern were wages and prices in the steel industry. The price of steel was seen as a key to the inflation problem and, indirectly, to the troubling gold outflow. Beyond that, an increase in the price of steel was seen threatening the American rate of economic growth, thereby undermining our attempt to keep up with the Soviet Union. So central was steel perceived to be that in 1962, when U.S. Steel and other steel companies announced a price increase, their executives were denounced as unpatriotic by the president and were forced to rescind it.
Does any of that sound like today's economy? Gold is no longer used for international monetary transactions. Indeed, the 1944 Bretton Woods exchange rate system, which fixed the dollar's value in gold and relative to the other major world currencies, disappeared in the early 1970s. The Soviet Union no longer exists. The American steel industry is a mere shadow of its former self and its prices are basically set in international markets. "Big labor" now represents less than one out of 10 workers in the private sector.
Today's economy is not especially inflation-prone. A few representatives of "big labor" and "big business" do not determine the rate of inflation. Most workers are not in a position to "demand" pay increases. And even if the inflation rate were to increase, bringing it back down to an acceptable level would not entail the kind of deep recessions that occurred in the long-past era of stagflation. If there is a risk in today's economy, it is that the Fed fighting the last war will overreact and push interest rates into recession territory.
Daniel J.B. Mitchell is the Ho-su Wu Professor of Management and Public Policy at the University of California at Los Angeles.
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