Despite its ominous onset, the present economic downturn seems to be accompanied by less uncertainty and fear among investors and businessmen than many of its predecessors. This reflects, in part, the successful stemming of the 1974-75 recession, which increased the belief that monetary and fiscal policies would be eased significantly and that they could contain even sharp downturns. With inventories under better control, businessmen feel better prepared for this decline.
An important factor affecting reactions to this recession is reduced confidence in the ability of Washington policy-makers to control inflation. The second episode of peacetime double-digit inflation in 1979 was a jarring experience for our society that incited inflationary expectations, and induced inflation-based behavior, among consumers and investors more than ever before.
As a result, the question being asked even as this deep recession just gets under way is whether the coming economic recovery -- which almost everyone believes is assured -- will lead to another period of double-digit inflation.
The past five years experience has resulted in an environment of expectations that increases the risk of a return to high inflation, but that could still be overcome. If recessions -- even severe ones like the present -- engender less fear and uncertainty than their predecessors, they are likely to have a smaller dampening effect on inflation. If double-digit inflation is now viewed as the normal climax of a U.S. business upswing, efforts by consumers and businessmen to protect themselves from it would hasten its reemergence.
After falling to unsustainably low levels later this year as a result of the recession, declining mortgage rates and slower oil price hikes, consumer price increase are likely to pick up again and oscillate within an 8 to 9 percent range for most of 1981. The path of inflation in 1981 and beyond depends on the speed of the economic recovery and the pitch of inflationary fears, both of which will be affected by government policy.
Several considerations suggest a slower-than-usual recovery from this recession and inflation continuing to trend downward for a while, although the pattern in neither growth nor prices is likely to be entirely smooth.
First, the federal budget, although in large deficit because of the recession, should be less stimulative than in earlier similar periods, since the tax increases already destined to occur in 1980 and 1981 are likely to exceed any coming reductions.
Second, the Federal Reserve may foster an earlier than normal upturn in short-term interest rates in this recovery as a consequence of its greater attention to the monetary aggregates -- the various measures of money supply. The Fed may be pushed further in the direction by a weakening dollar exchange rate when the U.S. recession and the technical drop in the Consumer Price Index end. Indeed, the first confrontation between the Federal Reserve and reawakened inflationary expectations could develop early in the recovery, and its outcome would have a major effect on the outlook.
Third, the political influence of high unemployment on economic policy should abate for a while after the November elections and in the initial period of the next administration.
Finally, the absence of a major inventory cycle implies that inventory accumulation will give economic growth less of a boost afte the recession.
Countering these factors are a number of risks and one important limiting condition on U.S. progress against inflation in the long run. There is a significant risk that at some critical junction the Federal Reserve will be misled again into believing its policy is not overly stimulative by a shift in the relationship between the monetary aggregates and economic activity. Such shifts confounded monetarists often during the past five years, particularly in late 1978 and early 1979.
The weakened foreign position of the United States raises the risks of an inflationary catchup in military spending, disruptions in the Persian Gulf and another round of large oil price increases.
And most important, the long record of past U.S. failure at controlling inflation suggests that American society still views the net costs of inflation as less than the pain of the existing cures. Therefore, unless the costs of inflation loom larger in the public's consciousness of new policy approaches involving less pain and hardship are developed, support for anti-inflation policy may ebb before it is completely successful.
On balance, it still seems more likely that the 1980 recession and the early stage of the following recovery will be a respite instead of a break, in the postwar price rise.