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U.S. Faces New Round of Inflation

May 14, 1985|Michael K. Evans | Michael K. Evans is president of Evans Economics Inc., a Washington-based economic consulting and forecasting firm. Recently he started Evans Investment Advisors, a Washington money-management firm

The good news about the economy is that, buoyed by strong consumer spending and housing, real growth will return to the 4%-to-5% range by midyear. The bad news is that this will bring about double-digit growth in the money supply, higher inflation and higher interest rates.

While the decline in growth from 13% to 4% in the consumer price index during 1981 and 1982 was quite unexpected by economists, it is easy in retrospect to identify the factors that caused this decline. The stability and then decline in oil prices reduced inflation by 3%; so did the strengthening of the dollar. Productivity reduced inflation another 2%, and the decline in interest rates (which used to be included in the consumer price index) also took about another 2% off. In addition, the disinflationary effects of both tight monetary policy and the recession, the more pliant attitude of labor because of foreign competition and the lower wage gains because of the personal income tax rate cuts all reduced inflation as well.

However, we cannot escape the sad reality that none of these factors is still in place. Energy prices have now started to rise, and, while they may back off in the summer, we have seen them bottom at $27 per barrel. The dollar is in the process of declining perhaps 20% over the next three years; the peak values reached in March will hold over the remainder of this business cycle. Productivity gains have once again become anemic. Interest rates certainly will not fall further before the next recession; in fact, they are expected to rise as much as 2% by mid-1986, although this has a much smaller effect on inflation as measured by the consumer price index since the mortgage rate was removed from that index.

Inflation Will Rise

Finally, with the unemployment rate on its way down to 7%, the slight decline in the dollar and a further improvement in profits this year, labor will be less likely to accept a cut in real wages for the third year in a row. In many cases, employees will not have another tax cut to cushion this decline. As a result, inflation will rise from its recent level of 4% to 6% by year-end.

While the dollar may rally slightly in the next few weeks, it will be 5% to 10% below current levels by year-end for several reasons:

First, foreign investors now realize that the growth of the U.S. economy for the remainder of this business cycle will be more moderate, and hence investment opportunities in the private sector will not be quite as profitable as before. Any tax increase legislated this year would simply add to that feeling.

Second, economic growth in Europe has recently improved. While it was clearly in the doldrums in 1982 and 1983, recent forecasts show some signs of life on the Continent for this year and next.

Third, while interest rates will be rising in the United States, so will inflation, and hence the real rate of return will remain unchanged. More importantly, the rise in interest and inflation rates means that bond prices will decline, and hence the total return--yield plus capital gains--will diminish sharply. For all of these reasons, foreign investors have already started to diversify their portfolios by lightening up on dollar-denominated investments.

Oil prices are likely to mirror the behavior of the dollar. The stated capacity of the Organization of Petroleum Exporting Countries is so far above current production levels that, even if the world economy were to double its overall growth rate and if the conservation ethic were somehow to be tossed to the winds, the demand/supply balance would not affect oil prices for at least five--and probably 10--years.

Tighter Grip on Oil Prices

This had led some forecasters to predict that oil prices will continue to head down. Yet by permitting--perhaps even encouraging--prices to drop to current levels, the Saudis have essentially accomplished their aims of (a) discouraging alternative sources of supply, (b) blunting any further advancement of the conservation ethic and (c) showing they were capable of ruining the petroleum industry and much of banking in this country by pushing prices even lower. Now they have withdrawn from the brink, and prices will again be more tightly controlled.

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