I n t h I s c h a p t e r y o u w I l L

T h e V i r t u o u s C i r c l e
o f L o w I n f l a t i o n
B
Y
J
ACOB
M. S
CHLESINGER
Why does inflation remain so low?
Some experts credit greater cor-
porate efficiency. Others cite a growing
labor force. Luck, in the form of cheap oil
and a strong dollar, helps. But the raging
economic debate often overlooks one
simple answer: because inflation remains
so low. In other words, it isn’t just a mat-
ter of mathematical formulas such as a
Phillips-curve tradeoff between inflation
and jobs; it also is the nebulous matter of
mass psychology. The economy may be
entering a phase in which low inflation is
no longer considered a lucky, transitory
phenomenon but an integral part of its
fabric. And if enough executives, suppli-
ers, consumers and workers believe it
will last, they will act in ways that help
make it last.
“For the past couple of years, peo-
ple were expecting inflation to rise, but
it hasn’t,” says Janet Yellen, the chief
White House economist and former Fed-
eral Reserve governor. “Slowly, people
are being convinced that inflation is
down and it’s going to stay down,
[which] is helpful in keeping inflation
down. Inflationary expectations feed
directly into wage bargaining and price
setting.”
This substantial exorcising of the
inflationary specter flows partly from
the Fed’s new credibility: a widespread
belief that it is committed to keeping
prices relatively stable and knows how to
do so. . . .
A widely cited measure of public
attitudes, the University of Michigan’s
Survey of Consumers, is reflecting two
significant changes this year, says
Richard Curtin, its director. First, long-
term inflation expectations—the pre-
dicted annual inflation rate for the next
five to 10 years—have slipped below
3% for the first time since the survey
began asking the question nearly two
decades ago. Second, long-term inflation
expectations now nearly equal short-
term expectations. . . .
This outlook eases inflationary pres-
sures in many ways. Recall the 1970s,
Ms. Yellen says, “when expectations of
future inflation led workers to demand
wage increases that would compensate
them for expected inflation, and firms to
give wage increases believing they could
pass on price increases.” . . .
“In the 1970s and 1980s, we had
price increases baked into our projec-
tions,” says Warren L. Batts, chairman
of both Premark International Inc. and
Tupperware Corp. and head of the
National Association of Manufacturers.
“We thought we could charge our cus-
tomers [more], and therefore we could
pay our suppliers. [Now], you know you
can’t charge, so you don’t pay.”
Of course, inflationary fears aren’t
completely cured, as last week’s stock
and bond market jitters show. Rampant
inflation in the 1970s shattered the no-
tion that America was immune to the
problem. Remaining traces of apprehen-
sion may not be all bad. “The moment
we become complacent about infla-
tion,” says Deputy Treasury Secretary
Lawrence Summers, “is the moment we
will start to have an inflation problem.”
S
OURCE
:
The Wall Street Journal,
August 18, 1997,
p. A1.
I N T H E N E W S
The Benefits of Low
Expected Inflation

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7 7 5
however, the economics profession would turn its attention to a different source of
shifts in the short-run Phillips curve: shocks to aggregate supply.
This time, the shift in focus came not from two American economics professors
but from a group of Arab sheiks. In 1974, the Organization of Petroleum Exporting
Countries (OPEC) began to exert its market power as a cartel in the world oil mar-
ket in order to increase its members’ profits. The countries of OPEC, such as Saudi
Arabia, Kuwait, and Iraq, restricted the amount of crude oil they pumped and sold
on world markets. Within a few years, this reduction in supply caused the price of
oil to almost double.
A large increase in the world price of oil is an example of a supply shock.
A