ROBERT J. GORDON NorthwesternUniversity Can the Inflalon of the 1970s be Explained? BY MANY STANDARDS inflationhas been a "surprise"during the past six years. Errorsin forecastinginflation have increasedmarkedly compared with earlierperiods. For instance,during the interval 1971:3 to 1975:4 the root mean-squareerror of the Livingstonpanel of economistsin fore- castingthe consumerprice index six months ahead was 3.5 percentage points at an annualrate, comparedwith an errorof 1.6 percentagepoints over the previousseventeen years.' Not only did the panel forecastersfail to predictthe increasedvariance of the inflationrate in the 1970s, but also they fell far shortin predictingthe cumulativetotal price changebetween 1971 and 1976-24.0 percentcompared with the actual change of 34.0 percent.2Most of the error occurredduring the four quartersof 1974, Note: This researchhas been supportedby the National Science Foundation. I am grateful to my research assistant, Joseph Peek, for his superb efficiency in compiling and creating the complex data base on which the paper depends. Helpful suggestions were received from participantsin seminars at Northwestern,the University of Cali- fornia at Berkeley, and the Federal Reserve Banks of San Francisco and Philadelphia. 1. The Livingston forecasts were obtained from John A. Carlson, "A Study of Price Forecasts,"Annals of Economic and Social Measurement,vol. 6 (Winter 1977), table 1, pp. 33-34. I calculated the errorsby comparingthe six-month-aheadforecasts with the change in the consumer price index in the two relevant quarters. For in- stance, Carlson's calculation of the predicted quarterly rate of change between December 1973 and June 1974 is comparedwith the average quarterlyrate of change of the CPI in the first and second quartersof 1974. The "previousseventeen years" runs from 1954:1 to 1971:2. 2. The actual figure refers to the sum of the quarterlyrates of change of the CPI in the interval 1971:3 through 1976:2. The forecast figure is the sum of the six- month predicted changes calculated by Carlson from the Livingston panel data for the ten surveys between June 1971 and December 1975. 253 254 Brookings Papers on Economic Activity, 1:1977 with an actualincrease of 11.6 percent,almost twice the 6.0 percentin- creaseforecast six monthsin advance.3 In searchingfor an explanationfor this inflation,this paper can be likened to an investigativereport following a railroador airline crash. The news of the disaster-in this case, the failure to forecast inflation accurately-was reportedlong ago and by now is well known. But what can we say beyondthe fact that the disasteroccurred? Just as transporta- tion investigationsattempt to determinewhich specificparts of the ma- chinefailed, and to recommendimprovements, so here the relationshipof the inflationrate to other importanteconomic variables is studiedto de- termineas preciselyas possible what was differentabout the experience of the 1970s, and what lessons can be learnedfrom past mistakes.Which theories and structuralrelationships relevant for predicting inflation remainintact, and which require surgeryor euthanasia?What are the implicationsfor policy? Most econometricmodels base their inflationforecasts on structural price and wage equations,either a single pair for the aggregateeconomy, or a largerset of disaggregatedequations. In my own past work on infla- tion, I have specifiedand estimatedaggregate price and wage equations, and have studiedthe sensitivityof the resultsto alternativespecifications, estimationmethods, and sampleperiods. This paperinvestigates the per- formanceof my price-wagemodel in trackingthe inflationof the 1970s, and studies the implicationsof its successes and failuresfor the future conduct of economic policy. The paperis dividedinto threesections, one on the priceequation, one on the wage equation,and one on dynamicsimulations in which the two equationsinteract. 1. Structuralprice equation. An equationthat explains price change with wage changeas a predeterminedvariable is a componentof almost all large-scaleeconometric models of the U.S. economy. In a previous paperI arguedthat the total increasein prices relativeto wages between mid-1971 and late 1975 was almost exactly what would have been pre- dicted by a structuralprice equationfitted to the 1954-71 period, and 3. The errors for the forecasts from five large-scale models compiled by McNees were similar. The four-quarter-aheadforecast made in 1973:4 for the change in the GNP deflator to 1974:4 was 6.04 percent; the actual was 11.04 percent. See the re- vised reprintof Stephen K. McNees, "An Evaluation of Economic Forecasts: Exten- sion and Update," New England Economic Review (September/October 1976), pp. 30-44. Robert J. Gordon 255 that the timing of postsampleerrors was consistentwith the hypothesis that prices had been held down by controls in 1971-72 and then re- boundedwhen controls were terminated in 1974.4This paperextends this test throughthe end of 1976, notes the effectsof recentdata revisionson the originalprice equation,and explores alternativeexplanations of its overpredictionof pricechange in 1975 and 1976. 2. Structuralwage equation. Can a wage equationspecified in 1971 and estimatedfor pre-1971 data explain the behavior of wage change since 1971? Whatwas the impact of 1973-74 "supplyshocks" on wage change, and how should policy respond to future supply shocks?5Has high unemploymentduring 1975 and 1976 held down wage increasesby moreor less thanwould have been expectedon the basisof pre-1971rela- tionships?Finally, can the pre-1971 data or the 1971-76 experience distinguishamong the variousproxies for labor markettightness used by differenteconometric investigators?" 3. Dynamic simulations.How potent are high unemploymentand a slack economyin slowingthe inflationrate? What would have been the consequencesfor inflationof an alternativeexpansionary policy in 1974? Is the Carteradministration's planned economic recovery consistent with its goal of deceleratinginflation? A dynamicsimulation in whichthe price and wage equationsinteract can provideanswers to these questions. Behaviorof the Main Variables,1969-76 Table 1 displaysthe behaviorover the 1969-76 period of severalim- portantmeasures of changesin prices, wages, money, and nominal de- mand.The figuresare annualrates of change.The firstcolumn covers the ten quartersprior to the impositionof the controlsprogram in 1971, the second column covers the two quartersinfluenced by the 1971 freeze, and the next five columnsshow for the five years 1972-76 the sum of the quarterlyrates of changefor the four quartersof each year. The official price indexes displayedin the first four lines uniformly 4. Robert J. Gordon, "The Impact of Aggregate Demand on Prices," BPEA, 3:1975, pp. 613-62. 5. See Robert J. Gordon, "AlternativeResponses of Policy to External Supply Shocks,"BPEA, 1:1975, pp. 183-204. 6. Robert J. Gordon, "Inflationin Recession and Recovery," BPEA, 1:1971, pp. 105-58. _~~~~~~~~~~~~~~~~~~~~~~~~ ^ 4> - N 9C2. OM 0\ cn enen en cn tn e u AY ~~~~~~~~~~~~~~~~~~~~~~~~~~~~tNXNoW A=3- ** so m W o Oo o mt looS.U e~~~~~~2 o $:~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~C^ s .5- 1 !~~~~~~~~~~~~~t., eq 0 N o N W- o C tr .4 V 3 > >, t to~caN m 0t r-o W W N tn t_ D EX > X A. > B~~~~~~~~~~~~~~~~~~~~~~~~~~~~C C; o- C;X n ~~~~~~~~~~~~~~~~~~~~~~~~~~~OX ^XXOWbX. l' 4-- a Xt>% O"W4"0 bb X -- OF x PC C to C3E - | t > Cmt N ^ q X,I m m n W | aa W~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~CWI J rB 9. o e X~~~~~~~~~~~~~CIR:l tn C m \ t N OSaN bWootQ cl ,, m$>EadEIc ? > * 1c ?c t?- g 0 SE St Q O r w n @ ar =~~~~~~~~~~~~~~~~~~o8 g aX S , WE i E*6 :<D ?9 X 5 3 a m -?;. g3? b g a g3r a; g NO v v Z; i ? t ?~ > m r P Robert J. Gordon 257 recordlittle pricechange in late 1971 and 1972, double-digitinflation in 1974, and a returnin 1976 to ratessimilar to or below those of 1969-71. The fifth line displaysthe "nonfood,net of energy"deflator that I de- velopedearlier, as recomputedfrom the revisednational income accounts and extendedto the end of 1976.7This index missesdouble-digit infation in 1974 by only a hair. Two wage indexes are displayednext. The first is compensationper manhour,with an adjustmentfor overtimeand shifts in the interindustry employmentmix; this is used as an independentvariable in the structural priceequation. The secondis the officialindex of adjustedhourly earnings compiledby the Bureauof Labor Statistics,further adjusted here to in- clude fringebenefits; this is the dependentvariable in the wage equation. The most notable differencebetween wage and price behaviorover this periodhas been the lowervariability of wagechange-less slowdowndur- ing late 1971 and 1972, less accelerationin 1974, and less deceleration between 1974 and 1976. As in the case of prices, wage changein 1976 returnedto roughlythe same rate as in 1969-71-a bit higherfor com- pensation,and a bit lower for averagehourly earnings. The final section of the table displaysthe growthof final demandand two measuresof the money supply.In none of these was growthnearly as variableas pricechange. The differencebetween the minimumand maxi- mum annualrates of change in the 1972-76 period was 2.4 percentage points for demand,3.8 for M1, 3.3 for M2,but 6.9 for the GNP deflator and 8.2 for the CPI. Simple reduced-formregressions in which price changeis regressedon a distributedlag of past changesin money or final sales confirmthat virtuallynone of the varianceof inflationin the 1970s can be attributedto the behaviorof moneyor final sales. When estimated for 1954-71,