Economic Report President

probably would have increased by about 2.6 percent last year, almost ½percentage point faster than during 1997. On the other hand, coreprices as measured by the chain-weighted price index for PCE excludingfood and energy decelerated during 1998; this index increased by only1.2 percent at an annual rate in the first three quarters of the year, comparedwith a 1.6 percent rise during 1997. The CPI and PCE priceindexes differ in both coverage and methodology (as discussed later inthis chapter). But by either measure, core inflation has dropped, on net,over the past several years. Indeed, core inflation has been lower duringthe past few years than at any time since the mid-1960s.Several factors have helped to hold down core inflation despite thestrong growth of aggregate demand and very tight labor markets. (Theforecast section of this chapter further explores the reasons for recentlow inflation.) Part of the reason why wage increases have not putmore pressure on prices has been rapid productivity growth. In addition,corporate profits stand at roughly their largest share of nationalincome during the past 30 years, and some wage increases have beenoffset by reduced profit growth of late. Another important contributionto low inflation has been declining prices of nonoil imports, as excesscapacity in Asia and depreciating foreign currencies have encouragedforeign producers to reduce the dollar prices of their goods. Beyondtheir direct impact on the prices paid for imports, these overseas developmentshave discouraged domestic producers from raising theirprices as much as they might have otherwise. Inflation has probablyalso been restrained by the strong increase in industrial capacity in theUnited States during this expansion. Although the unemployment ratewas at a 29-year low in 1998, the average rate of capacity utilization inindustry during the year was about equal to its long-term average.Low inflation readings in 1998 were reinforced by a continued slidein expected inflation. Actual inflation depends on expectations of inflation,because the wage and price increases sought by workers andfirms are influenced by the prices they expect to pay for other goods.According to the University of Michigan’s survey of households, themedian expectation for annual inflation over the next 5 to 10 years wasabout 2.8 percent in the fourth quarter of 1998, slightly below the late-1997 figure of 3.1 percent and well below the 3.6 percent reading of 6years ago. Long-term inflation expectations of professional forecastersare even lower, according to the survey conducted by the FederalReserve Bank of Philadelphia, but have fallen by a similar amount inrecent years.FINANCIAL MARKETSThrough much of the current expansion, falling interest rates andrising equity prices have provided important support to real economicactivity. Indeed, the disruptions to foreign financial markets and55