While Inflation Sleeps, Recovery Has A Fighting Chance

What could go right in 1992? Inflation could easily be the most pleasant surprise. Except for a few pockets of resistance, price pressures are virtually nonexistent--and likely to remain so.

Low inflation is a cornerstone of the recovery process. It gives the Federal Reserve more freedom to push short-term interest rates as low as needed. It keeps upward pressure off long-term rates that are crucial to housing demand and to the reliquification of business and consumer balance sheets. And low inflation boosts the purchasing power of household incomes.

Right now, economists expect the consumer price index to rise by about 3.5% during 1992. But given the economy's poor start in the New Year, along with prospects for a less-than-robust recovery, the CPI stands a good chance of coming in below that projection.

Going into 1992, service-sector restructuring is holding down the growth of service wages. That's a long-term phenomenon that will keep a lid on the growth of service prices (chart). And plenty of unused production capacity is keeping prices of goods in line. Although exports continue to be a plus for manufacturing, the poor outlook for domestic demand this winter means that even more capacity is likely to stand idle in coming months.

Oil is the wild card in the inflation outlook. OPEC's efforts to stem the recent $5-a-barrel drop in oil prices since November got a lift on Jan. 21 from Saudi Arabia, which voluntarily cut its production by 100,000 barrels a day. But with most major economies beset by recession or near-recession, weak world demand for oil will require sizable cutbacks to keep prices from sliding further. By mid-January, U.S. gasoline prices had fallen to where they were in July, 1990, before the Persian Gulf crisis.


The latest report on consumer prices looks favorable. The CPI closed out 1991 with a modest gain of 0.3%. Even excluding the volatile food and energy sectors, which can distort the underlying trend, prices were also up 0.3%. For the year, the CPI rose 3.1%. That was down from 6.2% in 1990, and it was the slowest rate since 1986.

Oil prices skewed those results, however. Because of the gulf crisis, energy prices had surged 18.1% in 1990 and then dropped 7.4% in 1991. Still, leaving out energy and food, the core rate of inflation came down by nearly a percentage point last year, to 4.4% from 5.2% in 1990.

That fundamental improvement should continue in 1992. In fact, during the final three months of last year, core inflation slowed to an annual rate of 3.1%. That was the best performance in any quarter in nine years--and an indication of how rapidly price pressures are easing.

The best thing the inflation outlook has going for it right now is a sharp deceleration in service prices, which had been a real problem area until about a year ago. Excluding energy, service inflation had hit 6.5% in early 1991, but by yearend, it had fallen to only 4.6%.

Prices of medical, educational, and personal services continue to rise rapidly, but the pace is slowing even in some of the toughest sectors. Prices of medical services, for example, rose 8% last year, but that's down from nearly 10% a year ago.

A bit surprisingly, goods inflation--excluding energy and food--has actually accelerated during the past year. Goods prices rose 4% in 1991, compared with 3.3% during 1990.

Medicine and education are problems here as well, but faster price growth in other areas, such as tobacco and alcoholic beverages, is a temporary result of tax hikes last year that will not be repeated this year.


To be sure, the outlook for goods inflation is bright. A chief reason is the depressed state of manufacturing and little prospect that consumer demand for goods will firm up anytime soon. Even if spending begins to pick up in the spring, factories are already operating at such low levels of capacity that their pricing power will remain weak through much of the year.

At the end of 1991, industrial production was falling. Output at factories, mines, and utilities dropped 0.2% in December--the third consecutive decline. A drop in utility output in December, the result of milder-than-normal weather, accounted for much of that month's weakness.

Manufacturing output rose only a scant 0.1% in December after a 0.3% dip in November and no growth in October (chart). Planned cutbacks by the auto industry in the current quarter do not bode well for factory production in coming months.

Output of construction supplies, up 0.4% in December and 0.5% in November, showed some strength. That's a sign that the modest upturn in homebuilding is one of the economy's few pluses. In December, housing starts rose 2.5%, to a 1.1 million annual rate. But for all of 1991, housing suffered its worst year in the postwar era.

Although sick domestic demand is the bane of the industrial sector, many factories can count on some growth in spending from foreign buyers. The merchandise trade deficit shrank by nearly half in November, to $3.6 billion from $6.3 billion in October.

After adjusting for inflation, exports are closing their gap with imports (chart). The already reported Japanese trade data suggest that the U.S. trade deficit likely widened again in December. But even so, the foreign-trade sector could have added at least 1% to real gross domestic product growth last quarter, at an annual rate. Given the weakness in domestic spending, that addition could mean the difference between positive or negative growth in the fourth quarter.

Exports rose to a record $37.5 billion in November, 0.9% above the previous high set in October. The best performers have been food and capital goods, where U.S. trade is firmly in surplus.

Developing countries have become our fastest-growing market, in part because many industrialized economies are slumping. U.S. exports to industrialized nations rose 3.4% in the first 11 months of 1991, compared with the same period of 1990. For developed countries, the pace was 14.2%. The biggest leap seems to be in Latin America. Exports to Mexico and Brazil are up 17%, while shipments to Venezuela have jumped by 54.4%.

Slack U.S. demand, however, has cut into the growth of imports, which fell a sharp 5.5% in November. Imports of nonauto consumer items fell 4.1% in November after posting big gains in the previous two months. Many of those goods were probably shipped in for the Christmas selling season. They may well have ended up in inventory, though, since retail sales were so poor in November and December. That means consumer imports should be weak in the next few months.


With domestic demand flagging, an increasing amount of U.S. production capacity is standing idle. The operating rate for all industry fell 0.3 percentage points in December, to 79%, and the rate in manufacturing slipped a tenth of a point, to a low 78.1%.

Capacity utilization is likely to dip even more in coming months, and it will be some time before operating rates come close to the 83% level that is associated with conditions that allow upward pressure on goods prices.

The favorable impact of low inflation on the buying power of consumers' incomes is already showing up in the data. In December, the real weekly earnings of production workers--adjusted for inflation--rose 0.7%. And from the fourth quarter of 1990 to the fourth quarter of 1991, real earnings increased, if only by a slim amount (chart).

Still, it was the first yearly gain since 1986. Weekly earnings before inflation have risen between 3.1% and 3.5% in each of the past five years, but because of last year's low inflation, wage earners saw their purchasing power increase.

Another good year for inflation in 1992 could lift real earnings for the second consecutive year--which hasn't happened in more than a decade. When the job market turns around, more buying power will give the economy a fighting chance at a consumer-led recovery.