Aug. 7 (Bloomberg) -- Whether the Federal Reserve got what it needed or the Treasury market got what it wanted, Friday's employment report solidified the view that policy makers will take a pass on another interest-rate increase when they meet tomorrow.

For the Fed, a fourth consecutive month of modest job gains (averaging 112,000) and a 0.2 percentage point increase in the unemployment rate to 4.8 percent were confirming, not deciding, evidence of the slowdown that is under way. The news validated policy makers' forecast that economic growth was downshifting to a ``sustainable'' pace, defined as one that does not strain the economy's potential and generate higher inflation.

Even if the employment report had been stronger, the Fed was likely to pause for credibility reasons. Fed Chairman Ben Bernanke first broached the subject of a pause in April 27 congressional testimony and was widely criticized for being soft on inflation. Inflation expectations, as derived from the spread between nominal and inflation-indexed Treasuries, rose.

That was followed by a month of ``hawks on parade,'' with every Fed official taking to the podium to emphasize his or her discomfort with accelerating inflation and determination to fight it at all costs.

By the time Bernanke testified in July, a pause was back on the table, at least conceptually, and the notion seemed to sit well with his previously critical financial market audience.

Given that many market participants have been critical of Bernanke for what they see as a Jekyll-and-Hyde persona, why go out of your way to reintroduce the idea of a pause if you don't plan to implement it?

Inconsistency Explained

What Bernanke's critics miss is there is nothing inconsistent about talking like a hawk on inflation -- that's what central bankers are paid to do -- and holding the federal funds rate steady to allow for the lagged effects of the prior 425 basis points of tightening.

If the Fed's forecast is wrong and inflation doesn't abate with slower growth, policy makers will raise rates again. In the meantime, by emphasizing the importance of price stability as both an end in itself and as a means of achieving maximum sustainable growth, the Fed hopes to prevent inflation expectations from becoming embedded. (Hey, if policy makers think rising inflation expectations are such a risk, why not talk up deflation as a goal?)

Inflation lags the economic cycle. In fact, the consumer price index for services holds the distinction of being one of seven select components of the Index of Lagging Economic Indicators. Why you would use today's inflation to make policy for tomorrow is anybody's guess.

Lagging Wages

As Bernanke told the Senate Banking Committee on July 19, ``We can't do anything about this month's inflation number, because our policy works with a lag, and so we have to be looking at a forecast, or the future, to make those judgments and to assess the risks.''

As for the concern inside and outside the Fed about rising wages -- average hourly earnings rose 3.8 percent in the year ended July -- the weight of the evidence supports the idea that prices (inflation) lead wages, not the other way around.

``While empirical evidence on the issue is mixed, tests that allow for a long-run relationship between wages and prices tend to find that price changes predict future wages, while wage changes do not have much effect on prices,'' write San Francisco Fed economists Benjamin Bridgman and Bharat Trehan (``What Do Wages Tell Us About Future Inflation,'' Jan. 19, 1996 Economic Letter).

Businesses, it seems, are much quicker to raise selling prices in response to increased demand than workers are to demand higher wages -- and get them.

Managing Risks

Wages are even one step removed from prices in terms of their value as a policy guide.

So when the Fed concludes its meeting tomorrow, the committee is likely to announce a pause, explaining the long and variable lags with which monetary policy operates.

Interest-rate futures markets concluded as much after one look at the employment report, reducing the odds of a rate increase to 16 percent, the lowest in almost two months.

What about the risk-management framework that Bernanke adopted from his predecessor, Alan Greenspan, a process that involves assessing the risks and acting to avoid the worst outcome? (Jim Bianco, president of Bianco Research in Chicago, defines that approach as ``make it up as you go along.'')

The risk is clearly that inflation will accelerate for technical reasons (the way imputed rental costs are calculated in the CPI) and as a result of past policy actions (the ``measured'' pace of rate increases, starting when the funds rate was at 1 percent, at a time when growth was booming).

Warm Welcome

Bernanke will emphasize those risks and leave no doubt that the Fed is prepared to act if their forecast is wrong.

Judging from the Treasury market rally in the wake of the employment report, such an outcome should sit well. Come the CPI report on Aug. 16, it could be time to play one-number-bingo again.

(Caroline Baum, author of ``Just What I Said,'' is a columnist for Bloomberg News. The opinions expressed are her own.)

To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net.

Last Updated: August 7, 2006 00:02 EDT