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August 7, 2006
Inflation and the labor market revisited
One of the nice things about blogging is that you can go back and revisit ideas from the past because the blog archives all of those old words and pictures as if you wrote them yesterday. For a professor, this is nice because invariably you want to bring up things that you discussed in the past, but a new set of students needs to get up to speed. In economics, it is essential to have access to that background. This post is in that spirit--just in time for classes to start in a couple weeks. Just about exactly one year ago I wrote this post that looked at the core CPI inflation rate and payroll employment starting from the trough of the last two recessions. Go back and take a look.
Here are the corresponding charts updated to the lastest data (including the labor market data from Friday).
The payroll charts tell us what we already know, but put it into context with the previous recovery. With the exception of the last few months, job growth has hovered around the 150,000 per month widely recognized as necessary to keep up with the growth of the population. There has not been the kind of robust recovery of jobs that came along after the 1990-91 recession.
Note also that the point in the recovery from the 1990-91 recession that corresponds best to today is early 1995. The labor market did experience a bit of a slowdown in 1995, and the possibility of recession was openly discussed. At the same time, inflation, which had been high at the start of the recovery, was starting to come down. This was the beginning of one of the most successful non-recessionary disinflations that this country has seen in the modern era. And in Feburary 1995, the Fed raised rates one last time by 50 basis points to 6.0% where it would stay until July when rates began to fall slowly for the next couple years.
Remember, the 1994-95 episode was a success in terms of a soft landing--a cooling of GDP to a sustainable pace, fall in inflation, and no recession.
Is it any easier to predict what is coming on the basis of this information than it was last year? Not really. I do have to say one thing, however. The totality of the picture is less encouraging than it was a year ago. Martin Feldstein shows his concern in Monday's Wall St. Journal opinion pages.
The Fed governors and Reserve Bank presidents appear to believe this [soft landing] will happen. Their "central tendency" economic projections, summarized in the July Monetary Policy Report, state that the Fed's favored measure of inflation, the PCE price index excluding food and energy, will decline from the 2.9% rate in the most recent quarter to between 2% and 2.25% in 2007, presumably on its way to Ben Bernanke's "comfort zone" of 1% to 2% in 2008. They project this to occur with real GDP growing above 3% and the unemployment rate remaining under 5%. Indeed, not a single one of the 19 FOMC members projected growth of less than 2.5% in 2007 or an unemployment rate above 5.25%.
Although this optimistic outlook is possible, experience suggests that it is unlikely. A mild slowing of economic growth is generally not sufficient to reverse rising inflation. That generally requires a sustained period of excess capacity in product and labor markets, with GDP growth falling significantly or even turning negative.
The last recovery being an significant exception to that rule, but as we have discussed, that requires everything to go right, especially productivity. Feldstein continues...
The official estimates of productivity growth showed a gradual decline of productivity growth in the nonfarm business sector from 3.9% in 2003 to 3.4% in 2004 and 2.7% in 2005. The result of the slower productivity growth and rising compensation per hour (from a 4% rate in 2003 to 5.1% in 2005) caused the increase in unit labor costs to accelerate from 1.3% in 2003 to 2.1% in 2004 and 2.8% in 2005. Taking the new GDP estimates into account is likely to lower the calculated productivity growth rates and cause estimated unit labor costs to have risen faster than 3% in the most recent quarter. There is no reason to anticipate a favorable productivity surprise of the type that contained inflation in the 1990s.
...
While this risk provides a rationale for a pause at tomorrow's meeting, it would be wrong to focus just on this downside risk. The probability that inflation will rise above the FOMC forecast is at least as great. The unemployment rate of 4.8% still represents a tight labor market. Waiting for more data before deciding to raise rates is not costless. If the Fed does not act and core inflation continues to rise, expected inflation may rise further. Higher expected inflation would cause faster increases in wages and prices. If the core PCE inflation rate rises above 3% in 2007, it would take a very substantial slowdown and a large loss of GDP and employment to bring it back under 2%.
In assessing the current interest rate decision, the FOMC members should recall that during the Volcker and Greenspan years the Fed pushed the fed funds rate to 8% above the concurrent rate of CPI inflation in the early 1980s, to 4% in 1989 and to almost 3% in 2000. That measure of the real fed funds rate is now less than 1%.
The Federal Reserve has a difficult task ahead. It is understandable that it would like to achieve the soft landing of low inflation with continued solid growth. But that may not be possible. And if the Fed wants to convince the markets that inflation will be contained in the future, it must show that it is willing to take the risk of tightening too much.
Feldstein is entirely correct to point out the real fed funds rate is still a bit low. This is what I have railed about time and again. If it is not possible to have the soft landing as we did in the '90s, then this meeting is a test of inflation fighting resolve. One long term lesson this episode may provide future generations of policy makers is just how important productivity growth is for cushioning the economy in situations like this. Without productivity growth, and worse yet with further increases in oil prices, it forces the Fed to go further than it would have ideally wanted in order to get the real rate where it needs to be. I am sympathetic to the argument that they should have raised rates faster in the early going (2004) to head off the rise in inflation. But in light of the weak labor market data--a labor market that the above charts show just never got off the ground the way it did in the mid-'90s--I can't say that I would have done anything differently. To raise rates too quickly while productivity growth rates were falling might have choked off the recovery even sooner.
On that note, I conclude with this little blurb from the NY Times.
DO WE HEAR A PAUSE? The central economic news of the week will emerge from the meeting of the Federal Open Market Committee, which will decide whether to raise the benchmark short-term interest rate — now at 5.25 percent — yet another time. On the one hand, many economists predict that the Fed will leave things unchanged, which would be welcome news for investors, but then again, who knows? The dearth of one-handed economists is legendary. (Tuesday.)
Try as I might to be single-handed, I can't say for sure what the Fed will do. I can come up with a lot of reasons to raise them one more time. I do worry a bit about the 6 to 18 month picture for inflation if they pause now. I'd like the increase to be now and the pause to be for the remainder of the year. But the markets have made up their mind, and Bernanke may not want to stir them up too much. They could very well send a strongly worded statement that though they pause now an increase in October is the default option unless new data changes that stance. If such a statement comes off as credible, it would be an acceptable compromise. We shall see.
UPDATE: The September meeting escaped my mind. Change the above to read September or October.
UPDATE 2: It gets worse. Michael Mandel reports that productivity figures for 2004 and 2005 are likely to be revised downward.
UPDATE 3: Mandel was correct. Productivity was revised downward for the last couple years and the 2nd quarter of 2006 came in at 1.1 percent growth. The trend is downward. While Mandel tries to tell a positive story of the 10 year productivity growth rates, his chart shows exactly what is troubling in this situation. In the mid-'90s, the trend was reversing and going up making it easier to contain inflation. Today, the growth rate of productivity is falling.
Posted by William Polley at August 7, 2006 2:30 AM
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