Created 10/22/1997
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The Current Boom

KQED Talking Points: 10/23/97


 Dynamic Forecasts of Inflation as of 1992
 Inflation, Unemployment, and the Federal Reserve
 Potential Output
 The Productivity Slowdown
 Warranted Stock Market Values
 Stock Market Forecasts

Dynamic Forecasts of Inflation as of 1992

IMAGE Imgs/KQED_Farnsworth01.gif

  • There has been a shift--a significant shift--in this decade with respect to how the
    economy's inflation and unemployment rates interact.
  • Given the unemployment rates we have seen recently, the inflation rate should   today be
    hitting five percent--if the economy were still behaving the same way that it behaved
    between the mid-1970s and the early 1990s. The red line in the figure above shows
    what we would have expected.
  • Why the difference?
    • The true answer is that no one really knows, but there are a number of theories, all
      of which seem plausible, and all of which may be contributing.
    • Workers have been so terrorized by the memory of the recession of 1982--and the
      near-collapse of the private-sector union movement in the 1980s as the Reagan-era
      NLRB switched from being the friend to the foe of the unions--that they are
      extremely, extremely slow to ask for wage increases, and hence inflation stays low
      even in a boom (likely to have had a large effect).
    • A better match between the skills of the labor force and the requirements of
      employers: a given unemployment rate today is associated with a much smaller
      vacancy rate than in the past, hence unemployment can go low without triggering
      inflation (likely to have had a large effect).
    • The Federal Reserve has done a good job of restoring confidence. No one fears
      rising inflation, so no one demands preemptive wage or price increases--and so the
      Federal Reserve no longer has to keep demand artificially low (as it had to do
      throughout the 1980s) in order to neutralize these preemptive increases.
    • The Federal Reserve has done a good job of lulling managers. Just as a lobster
      doesn't notice if you raise the temperature in its pot gradually, so businesses
      haven't noticed as demand pressure has been increased gradually--and so they have
      not recognized how much room there is for large-scale price increases (likely to
      have had a small effect).
    • Increased productivity growth and stable health-care costs have raised the real wage
      increases that firms can afford to give without requiring price increases (likely to
      have had only a small effect).

IMAGE Imgs/KQED_Farnsworth02.gif

Potential Output

The Productivity Slowdown

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  • (By contrast, actual dividend growth has averaged 1.6% per year above inflation over
    the past century and a quarter.)
  • Current stock prices are predicting not only a boom, they are implicitly predicting a
    doubling of the rate of economic growth--not something that there is any sign of
    anywhere outside the stock market.
  • Conclusion? The stock market today is as overvalued as the Japanese market was in

Warranted Stock Market Values

IMAGE Imgs/KQED_Farnsworth04.gif
  • Another possibility is that the risk premium--the premium expected return over bonds
    that investors demand for holding risky assets like stocks--has greatly shrunk, or
  • Once again, however, the current level of the stock market is just too high for such a
    story to make sense. I could believe that the risk premium had shrunk, but that would
    justify a Dow of 5500 or so--not 8000.

Stock Market Forecasts

IMAGE Imgs/KQED_Farnsworth05.gif


Created 10/22/1997
Go to
Brad DeLong's Home Page

Professor of Economics J. Bradford DeLong, 601 Evans
University of California at Berkeley; Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax