Bond markets around the world, with Germany and the U.S. in the lead, are celebrating the end of inflation. The immediate cause is the long-awaited slowdown of the U.S. economy. Markets had bought into the dogma that the Federal Reserve Board never has the foresight and resolve to act in time and stop inflation before it gathers momentum. They also had long believed that once the economy reached full employment, inflation would be just around the corner. For the time being, the markets have been proven wrong on both counts. The Fed has engineered a soft landing, and inflation, far from being around the corner, seems well down the road.
So much for the good news. The bad is that inflation remains unfinished business. Markets have swung from excessive skepticism to unreasonable confidence. Later in the year, they may well be surprised by a burst of inflation, especially if the slowdown in the U.S. proves temporary. The conviction that the recurrent problem of overheating is vanquished is premature.
Forecasts for inflation around the world show that in every major economy, inflation is beginning to climb--however modestly. In the U.S., according to The Economist's consensus forecast, consumer prices will rise 3.7% next year, compared with 3.3% this year, while in Germany, consumer prices will rise 2.7% in 1996, up from 2.3% in 1995. In the past, such small increases would have been shrugged off--inflation starts in earnest at 5% or 6%. Today, they should prod monetary authorities to respond or risk undermining the newfound confidence in moderate inflation. Central bankers must be even more watchful if output remains strong enough to prevent slack from developing in the economy. Otherwise, credibility will suffer, and a much more dramatic fight will have to be staged down the road.
HONEYMOON'S OVER. In some countries, such as Canada and Britain, the honeymoon of disinflation is over, though unemployment remains high. This will soon be true in Germany. The inflation reduction of the past few years has been impressive, but recent wage settlements have been uncomfortably large. Although a strong mark is containing inflation for now, the respite is temporary. Later in the year, German rates will have to rise, and that will force rates up throughout Europe. The Bundesbank was right in recent years to take a stand on inflation and drive it back down. But the task is incomplete, and a return to that vigilance is only a question of time.
For the past decade, inflation has averaged less than 4% in the U.S.--an important achievement. But that record will be tested in the year ahead. Over the past two years, inflation averaged only 2.4% annually. This year, it is expected to rise to 3.3%, and next year it could rise to as much as 4%. Wage settlements have been restrained by the wide-open, deregulated, competitive economy. Yet productivity growth is tapering off, wage restraint will weaken in the face of strong profits, and the large drop in the dollar and the boost in commodity prices are putting inflationary pressures in the pipeline. It does not take much to get from here to 4% inflation, and getting there will raise the question of just what level of price increases the Fed is prepared to accept.
POLICY SHIFTS? Victory over inflation is not won in a single battle. It requires steady vigilance and repeated and uncomfortable restraint every time the party gets going. Competition and open markets dampen the cyclical resurgence of inflation, but they most definitely do not eliminate it. We are not in a new world without inflation; we found that out in 1989-90 and will likely learn the lesson again within a year.
If and when the U.S. economy rebounds late in the year, higher interest rates will be appropriate--even if they risk bringing on a slowdown in the upcoming election year. Further, if election politics usher in tax cuts to fight the slack, the Fed would feel compelled to offset the stimulative effect with still higher rates. The politics of Fed policy will be complicated next April, when Chairman Alan Greenspan's term of office expires. Will President Clinton reappoint a Fed chairman who would be willing to slow the economy at such a delicate time, or will he shift Treasury Secretary Robert E. Rubin to the Fed, seeking to capitalize on Rubin's semiconservative credentials in order to get an expansion going without causing a ruckus in the bond market?
The past year may have been reassuring on the inflation front. But the real test of how much the Fed has changed and how committed it is to price stability will come over the next year. With these issues ahead, why is the bond market so complacent?