GEORGE L. PERRY BrookingsInstitution WhatHave We Learned about Disinflation? U.S. MONETARYPOLICY since 1979has been geared to stoppinginflation. It has had considerable success in doing so, but at a great cost in lost output and high unemployment, not only in the United States, but throughoutthe world. In Europeunemployment rose steadilyfrom 1979 to 1982 and is expected to rise further in 1983. In the United States, unemploymentrose to 10.7 percent at the troughof the recession in the fourthquarter of 1982,more than I1/2points above the previouspostwar recordreached at the worst point of the severe 1975recession. The durationof economic weakness in the presentdisinflation period distinguishesit from previous postwar recessions even more than the amountby which unemploymentrose and the level that unemployment reached. If the brief bounce-backin economic activity after mid-1980is ignored,the recent U.S. recession lasted twelve quarters.The previous postwar record was the five-quarterrecession of 1974-75. All other postwar recessions had lasted less than a year. By the end of 1983 the cumulativeexcess of unemploymentover its 1979level will be about 11 percentage point-years, correspondingto an estimated $700 billion to $900billion of forgone GNP in today's prices. This severe recession has been accompaniedby a dramaticslowing in the rate of inflation.Table 1 summarizesseveral measuresof inflation that reflect that slowdown, includingwidely used measures of actual inflationrates, which are affected by many special developments not closely associated with the underlying inflation problem, and some alternativemeasures of the underlyinginflation rate. Duringthe 1978- I thankJudith D. Kleinmanand PatriciaJ. Reganfor researchassistance. 587 (O 0 N TT'o C11 oo 1 (- (-o 0 o ooooo ~~0*.~0~0*. o-o t-- --oo ~o - 00 o., : 0 00 0 tr 06V ~ cl l (N0;; ~~00 mONOr?CN 10 _O .0~'~0O ON ONE o oo 0 ON -- 0S 000rO O. o cr NNooO FooooO O ON -- 0tNo -- - C ON oCo6o ~0 )-00 .00 0 0 3-~~~~~~~~~~~~~7 C ~~ ~ ~ ~ ~ ci ci CN rl 00 00 0 73- 0 ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ 3C Cu~ ~~~~~~~~~~~~~Z> - 73 0o0 CZ 0 0 ~ .0 ~ ~ ~ ~ z ~~~~~o > c Zou .Z w5 George L. Perry 589 80 perioda combinationof price increasesin food and energy (andrising interest rates as they affected the shelter component of the consumer price index) pushed the actual inflationrate to more than 10 percent, as measuredby any of the principalprice indexes shown in the top half of the table. In part because of the cessation or reversalof these develop- ments, these inflationrates slowed dramaticallyby 1982,and even more by the firsthalf of 1983. Both the accelerationof inflationand its subsequent slowdown are greatly attenuated in the measures of the underlying inflation rate displayedin the bottom half of the table. Nonetheless, the slowdown is still substantial,amounting to 4 to 5'/2 percentage points between the most inflationaryyear, 1980,and the firsthalf of 1983,using all measures except the volatile producerprice index, which has had a much larger swing. One important question raised by this experience is whether the disinflationthat has been accomplishedis more than might have been predicted on the basis of historical experience or whether it is about what would have been expected along with the huge recession that has occurred. The answer to this question, in turn, should shed some light on theoretical issues concerning how the economy works and on the options confrontingpolicymakers. In particular,a central issue to be consideredin light of the experienceof the past few years is whetherthe relation between output and inflationwill remainthe same when there has been a significantchange in the policy regime, such as that which occurredin the fall of 1979. Disinflation Policy and Inflation Models One model of the inflation process, the wage norm hypothesis, explicitly distinguishesbetween the cyclical variationin inflationand an ongoingnorm rate of wage increase aroundwhich the cyclical variation takes place.' Cyclical variationsin employmentand inflationare jointly determinedby the optimalresponse of firmsto variationsin the demand for their output. Althoughexpectations can, in principle,alter the wage 1. George L. Perry, "Inflationin Theory and Practice," BPEA, 1:1980,pp. 207-41; and Arthur M. Okun, Prices and Quantities: A Macroeconomic Analysis (Brookings Institution,1981). 590 Brookings Papers on Economic Activity, 2:1983 norm, in practicethis hypothesis relates historicalchanges in the norm to experienced,rather than anticipated,changes in the economy. In a wage normequation, shifts in the norm, such as those that would arise from sustainedepisodes of inflationor economic slack, show up empiricallyas shiftsin the constantterm. The coefficientsrelating output and inflationin the short run are determinedby institutionaland behav- ioral characteristicsthat are largely unaffectedby changes in macroec- onomicpolicies or by changesin the wage normitself. In empiricalwork, I have modeled historicalnorms as stable except for occasional discon- tinuous shifts.2 Because wage norms do not respond in a linear or systematic way to any one measure of economic performance-for instance, they would respond less to a large spurt in the CPI coming from supply shocks (1978-80) than to an equivalentincrease in the CPI associated with a sustained period of very low unemployment(1966- 69)-I preferredthis procedureto moreelaborate ways one mightmodel norm shifts. It has providedan adequate, simplecharacterization of the past. For the present episode, this model predictedthat the policy aimed persistentlyat disinflationwould eventually shift the wage norm down- ward, but only after imposingunusually great or sustainedweakness in the real economy. Under these conditions, the wage norm equation would begin to exhibit forecast errorsindicating that wage norms were shiftingdownward. Most empirical studies of wage or price inflation have used past inflationrates, ratherthan the concept of wage norms, to help explain current inflation. The effect of lagged inflation in these models has generally been interpretedas representingthe influence of inflationary expectations on currentinflation, where these expectations are formed by an adaptiveprocess. In such models, developmentsaffecting inflation continue to have an influencelong after they occur. And the effect of a sustained shock affecting inflation grows with the passage of time. Because the laggedinflation terms directly embody long-runand expec- tational effects, a sustained macroeconomicpolicy change is not ex- pected to altereither the constantterm or the coefficientsof the equation relatingoutput and inflation. 2. Perry, "Inflationin Theory and Practice." CharlesSchultze found this character- izationof normchanges explained inflation throughout the peacetimeyears of this century. See CharlesL. Schultze, "Some MacroFoundations for MicroTheory," BPEA, 2:1981, pp. 521-76. George L. Perry 591 New classical models differ in importantrespects from either of the modelsjustdescribed. They rejectadaptive expectations as a description of how futureprice expectationsare formed.Generally they relatethese expectations to the policies that are anticipated,but that idea has never been implementedin a widely accepted way in a predictive equation. The problem is in determiningwhat economic agents expect policy to be and what amount of inflationthey think will accompany it. These models also hypothesize that marketsalways clear and that in doing so they incorporateexpected futureprices in an importantway. In the pure form of such models, levels of outputand employmentdeviate from full employment levels only because economic agents are mistaken about policy now and in the future. They interpret the very flat short-run Phillipscurve estimatedfrom historicaldata as a reflectionof mistakes by economic agents resultingfrom unpredictablepolicies. The central policy implicationof this theory is that policy should be steady and predictable,a prescriptionusually interpretedas supporting monetarism.According to the theory, the mistakes of economic agents would be minimized under such a policy and the short-runrelation between output and unemploymentwould become very steep. If the monetarypolicy changeof 1979was understoodas a changeto a steadier and more disinflationarypolicy regime, this theory predictedthat infla- tion would slow more promptly and output and employment would decline less than historicalequations would forecast. A version of this theory associated primarilywith William Fellner stresses the credibilityof policy in a more generalway.3 In this version, what matters is that policy convincingly promises it will not tolerate inflation,quite apartfrom precisely how policy is conductedin the short run. The credibilityhypothesis also anticipatedthat the change in policy regime in 1979, once widely believed, would bringdown inflationmore promptlyand with a smallerloss of outputand employmentthan would be predictedby empiricalmodels fit to historicalperiods. And further- more, it predicts that the coefficientsrelating output and inflationin the short run will change under a consistent policy, making the apparent Phillipscurve steeper. As these formulationssuggest, some of the important, distinctive predictionsof these alternativehypotheses could be tested only after a complete cycle of disinflationand subsequentrecovery, when it would 3. William Fellner, Towards a Reconstruction of Macroeconomics: Problems of Theory and Policy (American Enterprise Institute, 1976), pp. 116-18. 592