2.7% Inflation Is Not ‘Extremely Low’

When the government reported the consumer price index for November earlier this month, Dan Rather told viewers of the “CBS Evening News” that the increase of 2.7% for the year to date, January through November, was “extremely low,” although higher than the rate of inflation for the like period of 1998. CBS, like other networks, portrayed the increase of 0.1% for November alone as joyous news that showed inflation was vanquished.

With the November figure alone, one cannot quarrel. Still, is a rise of 2.7% for 11 months--call it a year to simplify matters--nothing to worry about, as Rather seemed to suggest? Or is it more inflation than we consumers and our economic policy officials, in the White House and Congress as well as at the Federal Reserve, should regard tolerantly?

What about 2.75% a year? Compared to the double-digit inflation of two decades ago--13.3% in 1979 and 12.5% in 1980--it is comforting. Those double-digit increases two years in a row disturbed the public’s confidence that the U.S. economy was sound. They evoked references to hyperinflation in South America of more than 100% a year. Could it happen here? The public and the government were troubled.

The Federal Reserve under Paul Volcker slammed on the monetary brakes, driving interest rates up, hurling the country into a nasty recession and squeezing down inflation to 8.9% in 1981 and 3.8% in 1982.

The problem now is that memories of double-digit inflation induce complacency with rates that are lower--like 2.7%--but not negligible, and surely not equivalent to price stability.

How, exactly, should we consumers regard inflation of 2.7%? It was higher than the 1.6% for 1998 and 1.7% in 1997, and lower than 3.3% in 1996. So, it was somewhere in the middle. Is that acceptable? Is 2.7% “extremely low,” as CBS put it?

One way to address the question is to examine the consequences of inflation. Suppose it about equals the rate at which one’s salary or wage goes up? That means no gain of real income, no improvement in standard of living--unless one works more hours.

Consider what inflation does to the value of money. Over 10 years, 2.7% annual inflation shrinks the buying power of a dollar to 77 cents. Over 15 years, roughly the life expectancy of someone retiring, to 67 cents; and over 20 years to 59 cents.

Compare that to what I would call “extremely low” inflation--1% a year. In 10 years that compounds to 10.5% (a 90-cent dollar), in 15 years to 16.1% (86 cents) and in 20 years to 22% (82 cents).

To demonstrate a worse, but not worst, case: 4% inflation would shrink a dollar to 68 cents in 10 years, to 56 cents in 15 years and to 8 cents in 20 years.

In sum, the power of compounding is such that small differences each year accumulate to very sizable differences over spans of time that many of us can realistically anticipate for our own lives.

For federal employees, who get automatic cost-of-living adjustments, or COLAs, as do 90% of state and local government employees, inflation may not look so worrisome. Yet consider the 33 million people, working and retired, covered by private-employer pension plans. They will get automatic adjustments to their Social Security benefits, but their employer-paid benefits probably will be frozen, year after year, at their first-year level. According to the Employee Benefits Research Institute, only about 5% of defined benefit pension plans for medium- and large-sized companies offer an automatic COLA. Among smaller employers, the ratio is lower. A few employers have paid ad hoc, or lump-sum, COLA money.

Is 2.7% “extremely low” if one has a bank CD that pays 5% interest? At first glance, it would appear that the saver comes out with a net gain of 2.3%, not great but not nil either. Yet the interest, all 5% of it, is subject to federal and state income tax. Apply your own tax rate, subtract 2.7% inflation from your after-tax income and see what’s left.

Some people argue that a “little” inflation lubricates the economy and promotes full employment. This confuses cause and effect. Over-full employment may produce inflation, but the causality does not run the other way. The years 1997 and 1998 have shown that low unemployment and inflation below 2% can coexist, as some prices rise and some fall. On average, we do not have to settle for worse. Inflation of 2.7% a year, Mr. Rather, is not “extremely low.”