What Does This Recovery Need? Maybe A Little InflationGene Koretz
Inflation, as everyone knows, is No. 1 on the Federal Reserve's hit list, slated for eventual extermination. Indeed, "zero inflation" has become virtually a mantra in testimony by Fed officials before Congress.
To a number of economists, however, the goal of zero inflation, aside from its utility in mobilizing public support for relative monetary restraint, is misguided. "The truth," says Conference Board economist Albert T. Sommers, "is that zero inflation for the whole system is both unattainable and undesirable." In fact, he argues that a key element missing in the current recovery is "the kind of modest inflation or price firming that builds business confidence and helps fuel an accelerating cyclical upswing."
That absence, of course, is most apparent in the behavior of industrial commodities and intermediate goods, which usually spurt sharply higher as rising demand lifts the economy out of recession. The Commodity Research Bureau's spot price index of industrial materials, for example, has been weak all year (chart), as have other measures of materials and intermediate goods prices.
To be sure, consumer prices are still rising, though their 12-month increase slipped below 4% in August for the first time in more than three years. But Sommers argues that such inflation is also subsiding and moving toward the 3% level that is probably unavoidable in a mixed economy, where large sectors are either indexed to inflation or protected from downward price pressures.
"For the most part," he says, "there is no real cost-push or demand-pull inflation in the system right now-no basic goods inflation or income inflation in the personal or corporate sectors."
As Sommers and others see it, the failure to achieve the normal cyclical pickup in prices is inhibiting the kind of business behavior that guns the economy's engines. "Corporate spirits are low," explains Paul L. Kasriel of Northern Trust Corp., "because businesses are unable to improve their dismal profit performance by raising prices." Edward Yardeni of C.J. Lawrence Inc. notes that the ability to raise prices has typically been more important than volume sales growth in restoring profitability in the early stages of an upturn.
Indeed, weak prices may help explain the unusual combination of continuing inventory liquidation and continuing layoffs that characterizes the current recovery. "Price signals tell business that demand is firm enough to build inventories and that rising inventory values will offset the interest cost of holding them," explains Yardeni. And businesses that find they can't boost profits by raising prices, adds Kasriel, are choosing to cut costs by reducing payrolls.
One danger is that inflation has become such a bogeyman that a normal cyclical firming of prices-when it finally does arrive-will cause an adverse reaction in the financial markets and a premature shift toward restraint by the Fed. "That would be too bad," says Yardeni, "because the initial price surge in a recovery is usually followed by a decline in inflation as rising productivity allows companies to boost profits while moderating their price behavior."
For the moment, however, the danger of an overreaction to firming prices hardly seems imminent. Instead, says Sommers, "widespread price weakness is telling us that a normal, more rapid cyclical recovery is still a way off."
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