Presented to Local NABE Presented to Local NABE ChaptersChapters

Feb. 4, 2003Feb. 4, 2003 Los AngelesLos Angeles

Feb. 5, 2003Feb. 5, 2003 San San FranciscoFrancisco

Feb. 6, 2003Feb. 6, 2003 Silicon Silicon ValleyValley

Implications of Price Implications of Price Stability: Back to the Stability: Back to the 1950s?1950s?

Harvey RosenblumSenior Vice President

and Director of ResearchFederal Reserve Bank of Dallas

Implications of Price Implications of Price Stability: Back to the Stability: Back to the 1950s?1950s?

OverviewOverview

On the brink of price stabilityOn the brink of price stability Deflation possible, but unlikelyDeflation possible, but unlikely Bank profit squeezeBank profit squeeze Changed role for FedChanged role for Fed

First, some definitionsFirst, some definitions

InflationInflation– Generally rising pricesGenerally rising prices

DisinflationDisinflation– Declining inflationDeclining inflation

DeflationDeflation– Generally falling pricesGenerally falling prices

Price stabilityPrice stability– Prices, Prices, on averageon average, neither , neither

rising nor fallingrising nor falling

Consumer price Consumer price inflation: 1950 - 2002inflation: 1950 - 2002

-5

0

5

10

15

'50 '55 '60 '65 '70 '75 '80 '85 '90 '95 '00

12-mo. % change

Disinflation

PriceStabilityMid-50s

Inflation: Inflation: more recent more recent experienceexperience

0

2

4

6

8

10

12

14

16

1970 1980 1990 2002

12-mo. % change

Disinflation

RisingInflation

Q: Why do the ’80s & ’90s Q: Why do the ’80s & ’90s looklook different from the ’70s? different from the ’70s?A: Monetary policyA: Monetary policy

Microeconomic forcesMicroeconomic forces

Interrelated

GlobalizationGlobalizationNAFTANAFTADeregulationDeregulationImmigrationImmigrationTechnologyTechnologyCompetitionCompetitionProductivityProductivity

Monetary policy Monetary policy dial settingsdial settings 1970s1970s

– EasyEasy– EasierEasier

1980s and ’90s1980s and ’90s– TightTight– TighterTighter– Easy (1991-92 and 2001-02)Easy (1991-92 and 2001-02)

Monetary policyMonetary policydial settings dial settings (cont)

““Paul Volcker and Alan Greenspan Paul Volcker and Alan Greenspan set the real federal funds rate set the real federal funds rate three percentage points higher three percentage points higher than (Fed Chairmen) Arthur Burns than (Fed Chairmen) Arthur Burns and G. William Miller.”and G. William Miller.”

Romer and Romer (2002)Romer and Romer (2002)

Q: Does moneyQ: Does money growth matter? growth matter?

A: Yes, but not in the short-runA: Yes, but not in the short-run– Money growth and inflation closely Money growth and inflation closely

related over an eight- to ten-year related over an eight- to ten-year periodperiod

– BOTTOM LINEBOTTOM LINE: For short-run policy : For short-run policy making, money growth rates difficult making, money growth rates difficult to interpretto interpret

The Phillips CurveThe Phillips Curve

Declining unemployment implies Declining unemployment implies rising inflationary pressures, rising inflationary pressures, other things equalother things equal

The Phillips CurveThe Phillips Curve

0

2

4

6

8

10

12

0 2 4 6 8 10 12

Inflation (percent)

Unemployment rate (percent)

1961-70

The Phillips CurveThe Phillips Curve

0

2

4

6

8

10

12

0 2 4 6 8 10 12

Inflation (percent)

Unemployment rate (percent)

1974-83

1961-70

The Phillips CurveThe Phillips Curve

0

2

4

6

8

10

12

0 2 4 6 8 10 12

Inflation (percent)

Unemployment rate (percent)

1974-83

1984-92

1961-70

The Phillips Curve The Phillips Curve slopes slopes upup in the in the 1990s!1990s!

0

2

4

6

8

10

12

0 2 4 6 8 10 12

Inflation (percent)

Unemployment rate (percent)

1974-83

1993-01

1984-92

1961-70

The Phillips CurveThe Phillips Curve

Declining unemployment implies Declining unemployment implies rising inflationary pressures, rising inflationary pressures, other other things equal things equal

But: But: Other things are never Other things are never equalequal

During the 1990s, microeconomic During the 1990s, microeconomic factors overpowered the factors overpowered the importance of lower unemploymentimportance of lower unemployment

NAFTANAFTA

NAFTA became law in 1994NAFTA became law in 1994– Strengthened investment incentivesStrengthened investment incentives– Gave sense of “permanence” to trade Gave sense of “permanence” to trade

relationshipsrelationships BOTTOM LINE:BOTTOM LINE:

– Encouraged industries to reorganizeEncouraged industries to reorganize Enabled least-cost solutions that include Enabled least-cost solutions that include

MexicoMexico Boosted effective labor forceBoosted effective labor force

NAFTA impacts new NAFTA impacts new vehicle prices?vehicle prices?

-3

-2

-1

0

1

2

3

4

5

1990 1992 1994 1996 1998 2000 2002

New VehicleInflation

12-mo. % changeNAFTA begins

ImmigrationImmigration

New immigrants filled 5 million New immigrants filled 5 million jobs in 1990s jobs in 1990s

Legal immigrants accounted for Legal immigrants accounted for 40 percent labor force growth40 percent labor force growth

BOTTOM LINEBOTTOM LINE: Without : Without immigration, inflation pressures immigration, inflation pressures would have been severe.would have been severe.

DeregulationDeregulation

John Duca’s researchJohn Duca’s research– Deceleration of prices and wages Deceleration of prices and wages

most evident in sectors experiencing most evident in sectors experiencing deregulation and/or increased deregulation and/or increased foreign competitionforeign competition

TechnologyTechnology

““A four-billion-fold increase in the A four-billion-fold increase in the world’s raw automated world’s raw automated computational power in 40 years, computational power in 40 years, an average growth rate of 56 an average growth rate of 56 percent per year.”percent per year.”

DeLong and Summers (2001)DeLong and Summers (2001)

‘‘Nuf saidNuf said

CompetitionCompetition

Pricing power “disappeared” in the Pricing power “disappeared” in the ’90s’90s

Firms adopt new technology Firms adopt new technology because they have because they have NO OTHER NO OTHER CHOICECHOICE

Inflation paradigmInflation paradigmshifted in the ’90sshifted in the ’90s

1970s and early ’80s 1990s

Cost push Cost compression

cost price cost productivity

Pricing power Absence of pricing power

Inelastic labor supply Immigration & virtual

immigration

Adopting technology a choice Adopting technology an

imperative

Regulated oligopoly markets Deregulated,

contestable markets

with globalization

Disinflation Disinflation momentummomentum Might have attained price Might have attained price

stability by 2004stability by 2004

Today’s inflation Today’s inflation tug-of-wartug-of-war

Homeland securityHomeland security Federal deficitsFederal deficits War on two frontsWar on two fronts NationalizationNationalization

– Airport securityAirport security Re-regulation (Patriot Act)Re-regulation (Patriot Act) Globalization stallsGlobalization stalls

– Increased protectionismIncreased protectionism Restricted immigrationRestricted immigration

Post 9-11 inflation forcesPost 9-11 inflation forces

Today’s inflation Today’s inflation tug-of-war tug-of-war (cont)

Monetary policyMonetary policy Microeconomic factorsMicroeconomic factors

– Globalization/NAFTAGlobalization/NAFTA– Demographics/ Demographics/

immigrationimmigration– DeregulationDeregulation– TechnologyTechnology– ProductivityProductivity– CompetitionCompetition

1990s disinflation forces1990s disinflation forces Homeland securityHomeland security Federal deficitsFederal deficits War on two frontsWar on two fronts NationalizationNationalization

– Airport securityAirport security Re-regulation (Patriot Re-regulation (Patriot

Act)Act) Globalization stallsGlobalization stalls

– Increased protectionismIncreased protectionism Restricted immigrationRestricted immigration

Post 9-11 inflation forcesPost 9-11 inflation forces

BOTTOM LINE:1. Price stability postponed2. Deflation on hold

Q: On the brink of Q: On the brink of price price stability? stability? “I don’t know at what point welcome

disinflation might morph into unwelcome deflation. I don’t think we are there yet.”

Pres. Bob McTeer, Dallas FedNABE Annual Meeting, September 2002

A: YesA: Yes

Price stability: Price stability: SignpostsSignposts Mortgage rates in the low 4sMortgage rates in the low 4s Fed changes target Fed funds Fed changes target Fed funds

rate by one-eighth pointrate by one-eighth point Commonly-used inflation indices Commonly-used inflation indices

around 1 percentaround 1 percent Flat and low yield curveFlat and low yield curve

A basic principle of A basic principle of economics and financeeconomics and finance Long-run inflation expectations Long-run inflation expectations

embodied in long-term interest embodied in long-term interest ratesrates

Bond yields follow Bond yields follow inflation, with a laginflation, with a lag

0

2

4

6

8

10

12

14

16

18

62 66 70 74 78 82 86 90 94 98 02

Percent

10-year T-Bond

Inflation

Mortgage rate in low Mortgage rate in low 4s signpost of price 4s signpost of price stabilitystability

2

4

6

8

10

12

14

16

18

20

'50 '55 '60 '65 '70 '75 '80 '85 '90 '95 '00

Percent

Price Stability

IFIF the U.S. gets the U.S. getsto price stabilityto price stability Implications forImplications for

– BanksBanks– Money market fundsMoney market funds– The FedThe Fed

A basic principle of A basic principle of economics and financeeconomics and finance Long-run inflation expectations Long-run inflation expectations

embodied in long-term interest embodied in long-term interest ratesrates

What does this meanWhat does this meanfor interest rates?for interest rates?

What does this meanWhat does this meanfor interest rates?for interest rates?

0

2

4

6

8

10

12

14

16

18

1-Year 3-Year 5-Year 10-Year

Percent

Nov 2002Near price stability

What does this meanWhat does this meanfor interest rates?for interest rates?

0

2

4

6

8

10

12

14

16

18

1-Year 3-Year 5-Year 10-Year

Percent

May 1975

Nov 2002

Rising inflation

What does this meanWhat does this meanfor interest rates?for interest rates?

0

2

4

6

8

10

12

14

16

18

1-Year 3-Year 5-Year 10-Year

Percent

Sept 1981

May 1975

Nov 2002

High inflation

with tight monetary policy

What does this meanWhat does this meanfor interest rates?for interest rates?

0

2

4

6

8

10

12

14

16

18

1-Year 3-Year 5-Year 10-Year

Percent

Sept 1981

May 1975

Nov 2002

May 1955Price stability

Back to the 1950s?Back to the 1950s?

Mickey Mantle and Yogi Berra

Bank net interest Bank net interest margins margins

1

1.5

2

2.5

3

3.5

4

1953 1955 1957 1959 1995 1997 1999 2001

Percent ’53-’59 and ’95-’01

Return on assets (ROA)Return on assets (ROA)

0.4

0.6

0.8

1

1.2

1.4

1.6

1953 1955 1957 1959 1995 1997 1999 2001

Percent ’53-’59 and ’95-’01

Return on equity (ROE)Return on equity (ROE)

7

8

9

10

11

12

13

14

1953 1955 1957 1959 1995 1997 1999 2001

Percent ’53-’59 and ’95-’01

0

10

20

30

40

50

60

70

80

1934 1942 1950 1958 1966 1974 1982 1990 1998

Percent

Interest Expense

Salary & Benefits

Percent of total Percent of total expenseexpense

Price stability:Price stability:bottom line for banksbottom line for banks Reduced profitability (in the short-Reduced profitability (in the short-

run)run) Interest expense less importantInterest expense less important Salary/benefit expense control Salary/benefit expense control

more crucial than evermore crucial than ever Add “price-stability risk” to credit Add “price-stability risk” to credit

risk, interest rate risk and other risk, interest rate risk and other critical riskscritical risks

Money innovationsMoney innovations

Money Market Mutual Funds (MMFs)Money Market Mutual Funds (MMFs)– Early 1970sEarly 1970s– Offered by mutual fundsOffered by mutual funds

Money Market Deposit Accounts Money Market Deposit Accounts (MMDAs)(MMDAs)– Early 1980sEarly 1980s– Offered by banksOffered by banks

Over two-fifths of money supplyOver two-fifths of money supply

Money market fundsMoney market fundsa marriage of:a marriage of: RegulationRegulation

– Deposit interest rate ceilingsDeposit interest rate ceilings TechnologyTechnology

– Toll-free telephone numbersToll-free telephone numbers InflationInflation

M2 and its componentsM2 and its components

0

1000

2000

3000

4000

5000

6000

'60 '65 '70 '75 '80 '85 '90 '95 '00

$ billions

currencyFed money

M2 and its componentsM2 and its components

0

1000

2000

3000

4000

5000

6000

'60 '65 '70 '75 '80 '85 '90 '95 '00

$ billions

currency

checking

savings

CDs Old bankmoney

Fed money

M2 and its componentsM2 and its components

0

1000

2000

3000

4000

5000

6000

'60 '65 '70 '75 '80 '85 '90 '95 '00

$ billions

currency

checking

savings

CDs

MMDAs

New bankmoney

Old bankmoney

Fed money

M2 and its componentsM2 and its components

0

1000

2000

3000

4000

5000

6000

'60 '65 '70 '75 '80 '85 '90 '95 '00

$ billions

currency

checking

savings

CDs

MMDAs

MMFs

New bankmoney

Old bankmoney

Mutual fundmoney

Fed money

The Fed has The Fed has outsourced money outsourced money productionproduction

% of M2% of M2

Fed Money:Fed Money: CurrencyCurrency 1111

Bank Money: Bank Money:

CheckingChecking

SavingsSavings

CDsCDs4646

MMDAsMMDAs 2626

Mutual Fund Mutual Fund Money:Money:

MMFsMMFs 1717 43

Implications of Implications of sustained price sustained price stability for MMFsstability for MMFs Money funds shrink when rates Money funds shrink when rates

sinksink Shake-out in MMF industryShake-out in MMF industry Disruption of M2 statisticsDisruption of M2 statistics Disruption of business financeDisruption of business finance

– 32% of MMFs’ assets invested in 32% of MMFs’ assets invested in commercial papercommercial paper

– 45% of outstanding commercial 45% of outstanding commercial paper held by MMFspaper held by MMFs

Implications of Implications of sustained price sustained price stability for the Fedstability for the Fed Fed goal: Fed goal: Maintain Maintain price stabilityprice stability Change rates in smaller Change rates in smaller

incrementsincrements Respond aggressively to potential Respond aggressively to potential

deflationdeflation Fewer headlines for the FedFewer headlines for the Fed

Implications ofImplications ofprice stabilityprice stability

Conclusions Conclusions On the brink of price stabilityOn the brink of price stability Bank profit squeezeBank profit squeeze Mutual funds shake-outMutual funds shake-out Changed role for FedChanged role for Fed