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March 03, 2008
Today's required reading...
... is from the Wall Street Journal's Greg Ip. In today's piece, "For the Fed, a Recession -- Not Inflation -- Poses Greater Threat", he writes:
So why is the Fed more worried about growth than inflation? First, it thinks run-ups in commodity prices explain the increases, not only in overall inflation but also in core inflation: higher energy costs have "passed through" to other goods and services. Core inflation rose and fell with energy inflation between early 2006 and mid-2007, and the Fed thinks the same thing is probably happening now. If energy and food prices stop rising -- they don't have to actually fall -- both overall and core inflation should recede.
...
For the current high inflation rates to become permanent, the Fed believes it has to become embedded in how workers and businesses set wages and prices. So far, surveys suggest consumers haven't raised their expectations of inflation much. In last year's fourth quarter, hourly wages and benefits were up just 3% from a year earlier, a slowdown from 2006, even though unemployment was below 5% for almost all that period. A wage-price spiral requires wages to cooperate.
Wages are even less likely to accelerate if unemployment, now 4.9%, rises to 5.25% this year and falls only gradually to 5% by 2010, as the Fed's Federal Open Market Committee forecasts. That implies three years with the unemployment rate above the FOMC's estimated "natural" rate of about 4.9%, and thus steady downward pressure on inflation.
The notion that higher unemployment reduces inflation has its skeptics, even at the Fed. "All you have to do is recall the 1970s, when we experienced both high unemployment and high inflation, to appreciate that slow economic growth and lower inflation don't necessarily go hand in hand," Federal Reserve Bank of Philadelphia President Charles Plosser said last month.
I must say that I get a little nervous about pinning my hopes for inflation reduction on a forecast that unemployment will be a couple tenths of a percent over the supposed "natural" rate. Even if you believe in some kind of an expectations augmented Phillips curve, you have to wonder about what has been happening in recent weeks. The genie may not be out of the bottle yet, but it's beginning to look like someone popped the cork.
Ip continues,
Critics say the Fed also took too long to reverse the ultralow rates of 2001-2003, thereby fueling the housing bubble -- if not rampant inflation -- whose collapse now threatens the economy. Federal Reserve Bank of St. Louis President William Poole became one of the first people who participated in that decision to repudiate it. "With the benefit of hindsight...it is not hard to argue that the [Fed] was too slow to raise the federal-funds target after taking the target down to 1% in 2003," he said at a conference on Friday.
Even Fed officials who don't share that view agree that both that episode and the 1970s experience argue for promptly reversing rate cuts once the current crisis passes.
That's easier said than done. The Fed is unlikely to face an outlook so unambiguously positive anytime soon that such a reversal will be a slam-dunk, and during an election year, it will face intense political pressure not to raise rates.
Whether the Fed reverses course "on an appropriate schedule" will be clear in five years or so, Mr. Poole said.
This is not the first place I've seen this sentiment (of rate hikes as soon as this crisis passes) expressed recently. That makes me think that there is a concerted effort to manage expectations here. At this point, I'd say the most likely time for the Fed to want to begin tightening again (barring any unforeseen developments) will probably be very close to election time. It will be a tough sell. Better start paving the way soon.
And Poole's final comment is very much on the money.
Posted by William Polley at March 3, 2008 01:39 PM
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Comments
There is a (lagged linear) trade-off between unemployment and the change rate of labor force in the USA. This figure
http://www.geocities.com/iokitov/uelf5.gif
illustrates the link. As the figure shows, unemployment in the USA will be decreasing the next five years, with some possible real and measurement related monthly flucs, however.
Inflation is also on a downward trend.
Posted by: kio at March 4, 2008 03:34 PM
Any inflation pressure from energy and food prices could be easily offset by ending ethanol subsidies and opening the Gulf and ANWR to oil and gas drilling and extraction. Even though production would be several years in the future for oil and gas, OPEC and other oil and natural gas producers would respond quickly to the increase in supply. It's not like this crap is a mystery. As every politician nibbles at the periphery, the average consumer is hurt by regulatory and legislative policies.
kio, inflation on a downward trend is almost as scary as it being in a steep uptrend. The worst scenario possible is stagflation. While the general populace whistles, Rome burns.
Posted by: skh.pcola at March 5, 2008 01:01 AM
skh.pcola,
Fortunately, inflation and real economic growth do not depend on the Fed or any other person or organization. These are objective processes fully determined by the age structure of population and labor force participation rate. SO, any emotional approach like "scary" stagflation is not an appropriate way of economic analysis.
Posted by: kio at March 5, 2008 02:38 AM
Ivan,
How well does your model do for Zimbabwe?
Perhaps that's not a fair question. Or perhaps there is a way to argue that Zimbabwe's monetary policy (or that of Weimar Germany) is itself an endogenous response to changes in the LFPR. Maybe there is one heck of a feedback loop or something.
Maybe.
(Please note: I'm not predicting hyperinflation for the U.S. Not in the least. I am simply suggesting that policy matters.)
Seriously though, I am kind of curious as to how you would explain hyperinflation or even periods of high (but not necessarily "hyper") inflation. And then if there is, in your view, something different about those episodes, what that something is.
I have read some of your material from time-to-time. On one post, you claim that inflation in the U.S. will go negative (deflation) between 2011 and 2013.
http://inflationusa.blogspot.com/2007/08/inflation-and-unemploymet-in-usa-beyond.html
I'm not convinced. But right or wrong, I'll save this comment and pull it out 3 to 5 years from now.
Posted by: William Polley at March 5, 2008 11:44 AM