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Robert Samuelson

The End Of the Age Of Inflation

By Robert J. Samuelson
Thursday, December 2, 2004; Page A35

The Age of Inflation is finished. Over the past four decades, the rise and fall of double-digit inflation has been the most significant force affecting the U.S. economy. Inflation rose from a little less than 2 percent in 1960 to 13 percent in 1979 and then gradually descended to a little less than 2 percent in 2003. Going up, inflation generally harmed the economy -- causing harsh recessions, a stagnant stock market and lackluster gains in living standards. Coming down, inflation generally helped the economy -- leading to longer expansions, a stock market boom and stronger gains in living standards.

That's the Age of Inflation in a nutshell, but it's barely understood.

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One reason is simply the passage of time. Americans who were 20 in 1980, when double-digit inflation was at its most destructive, were barely old enough to appreciate what was happening. Yet, those people (now 44) are older than two-thirds of the population. They have no memory of rising inflation. As for declining inflation, its benefits have occurred in a gradual and almost invisible manner. We haven't paid much attention. Our economic debates blame or credit high-profile presidential policies (Reagan's tax cuts, Clinton's budget surpluses or Bush's deficits) or focus on more dramatic upheavals: the Internet or globalization.

Inflation mattered more than any of these.

Consider recessions. From 1969 to 1982, when inflation was highest, there were four recessions, including the two worst (1973-75 and 1981-82) since World War II. In 1982 unemployment peaked at 10.8 percent. Since 1982 the economy has suffered only two mild recessions (1990-91 and 2001). Put differently, the economy has expanded in all but 16 months of the past 22 years. Economists debate the causes of this smoothing of the business cycle, which they call "the great moderation." But the central cause seems obvious: lower inflation. Prices moved less abruptly. Government policies to suppress inflation (mainly tighter money, from the Federal Reserve) were deployed less often.

Low interest rates also signal the significance of declining inflation. Rates on 10-year Treasury bonds hover around 4 percent. By way of contrast, they were 12.4 percent in 1984, 8.6 percent in 1990 and 6 percent in 2000. Interest rates on home mortgages and corporate bonds have also declined sharply. This slow-motion drop in borrowing costs has silently propelled the economy forward in the past two decades. And interest rates dropped mainly because inflation dropped.

Here's why. Economists subdivide interest rates into three components: an amount compensating for expected inflation (investors don't want to lose money to inflation); the "real return" earned by the lender or investor; and, finally, an "inflation risk premium" -- an amount covering the risk that no one can predict future inflation. For example, the 12 percent rate on 10-year Treasury bonds in 1984 might crudely be decomposed as follows: 2 percent for the "real" return, 8 percent to compensate for expected inflation, and a 2 percent "inflation risk premium." As inflation dropped, inflationary expectations and the "inflation risk premium" shriveled, as a new study by economists Andrew Ang and Geert Bekaert of Columbia University confirms. (A technical note: The various components of interest rates don't exist in isolation; they have to be estimated.) Inflation influences interest rates more than, say, budget deficits do.

Inflation's fall also quietly boosted the stock market. At first, rising inflation killed stocks. In 1965 the Dow Jones industrial average opened at 874.13; in 1982 the Dow opened at 875 -- 17 years and no gain. Higher interest rates caused by higher inflation attracted money from stocks into bank deposits, money market funds and bonds. Inflation also eroded the value of corporate profits. But once inflation dropped, the process was reversed. Money flowed back into stocks; the value of profits rose. By January 1987 the Dow had doubled; today's level (about 10,500) is 12 times as much as its 1982 opening. People felt wealthier. They spent more. The economy advanced.

Declining inflation probably also improved productivity, though this is harder to prove. Productivity gains have recently averaged about 3 percent a year. These gains -- essentially, improved efficiency -- underlie increases in wages, profits and living standards. When inflation was highest, productivity gains were half their present level. Computers and the Internet are typically credited for the revival. But that's not the whole story. As companies found it harder to raise prices, they turned to new technologies and other cost-cutting techniques to improve profits.

The gains from purging double-digit inflation are a great untold story. The Federal Reserve's staunch anti-inflationary policies, and stiff competitive pressures (from imports to the rise of Wal-Mart), demolished the deadly wage-price spiral. We've been reaping the benefits ever since. These gains -- not Reagan's tax cuts or Clinton's budget policies -- mostly explain the economy's fabulous performance in the 1990s.

Some benefits (perhaps higher productivity growth and a smoother business cycle) may endure. But others, unfortunately, are fleeting. You can't repeat the benefits of the steep fall of interest rates from double-digit inflationary levels. The same is true of the extraordinary rebound of the stock market. It was a one-time recovery from inflation's damage. Future changes in inflation, interest rates and stocks will be smaller. Indeed, some economists now expect slight increases in inflation and interest rates. Deutsche Bank predicts that rates on 10-year Treasury bonds will rise to 5.5 percent by the end of 2005, the highest since late 2000.

The economy must now move ahead without the powerful afterburners of soaring stocks or rapidly falling interest rates. These were the final chapters of the Age of Inflation. It's over. What comes next is anyone's guess.


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