Long and variable lags.
I doubt that inviolable tenet of how monetary policy works is etched into the cornerstone of the Federal Reserve Board in Washington. It is, however, an article of faith for anyone who has ever worked there.
And yet, Fed Chairman Ben Bernanke and his core group of doves at the Fed seem comfortable with the overnight rate at an emergency-like 0 percent to 0.25 percent when the economy is growing at a modest pace, private-sector job growth has topped 200,000 in the last two months and sensitive raw materials prices are skyrocketing.
Where’s the justification?
At 8.8 percent in March, the unemployment rate is still unacceptably high for the dual-mandated Fed, charged with monitoring both unemployment and inflation.
And with no acceleration in wages -- average hourly earnings are stuck at a 1.7 percent annual increase -- Bernanke is comfortable he can minister to the unemployed without any adverse effects on intermediate-term inflation and inflation expectations.
That would be a mistake. Empirically, prices lead wages. If it were the other way around, wages would be in some kind of leading inflation indicator, such as the one created by the Economic Cycle Research Institute.
While the ECRI refused to discuss the composition of its Future Inflation Gauge when I called Friday, wages aren’t in the index because “they aren’t a good leading indicator of inflation,” a then-less-secretive research director told me in 2000.
Your Father’s Economy
Causation can run in both directions, with prices and wages feeding off one other, according to Gad Levanon, associate director of macroeconomic research at the Conference Board in New York. “Overall inflation leads both core inflation and average hourly earnings based on a cross correlation test.”
The Fed operates on the premise that core inflation, which excludes food and energy, leads overall.
The focus on wages is a residual from the wage-price spirals of the 1970s: no wage increase, no inflation.
Before deregulation -- when companies were shielded from outside competition -- labor unions could negotiate a contract for their workers, and the employer would pass the higher costs along to consumers in the form of higher prices.
Union membership declined to a 70-year low of 11.9 percent last year, according to the Bureau of Labor Statistics. For the first time in history, more union workers were employed by the government than by the private sector. Only 7.2 percent of the private-sector workforce was unionized.
Symptom, Not Cause
In today’s world, any union demand for a wage increase is likely to be met with a shift in production: from Michigan to South Carolina for the auto industry; from North Carolina to China for textiles.
To the extent that labor has any negotiating power in a de-unionized, globally competitive world, wages are set “based on last year’s inflation,” said Joe Carson, director of global economic research at AllianceBernstein in New York.
Think of wages as a price: the price of labor. They happen to be the biggest share of compensation costs in services industries. That still doesn’t mean they cause inflation. Rather, they are a symptom of it.
Some Fed bank presidents understand the central bank can’t wait to see higher wages before starting to withdraw the stimulus. The Minneapolis Fed’s Narayana Kocherlakota and Richmond’s Jeffrey Lacker are making noises about raising interest rates by year-end. The Philadelphia Fed’s Charles Plosser has talked about calling a halt to the central bank’s second round of quantitative easing, in this case the planned purchase of $600 billion of Treasury securities set to conclude in June.
For Bill Dudley, that talk is premature. Speaking in Puerto Rico Friday, the New York Fed president said unemployment is much too high (agreed); the “coast is not completely clear” for the U.S. economy (it never is); and commodity prices are experiencing “a little bit of a bubble” (this from the ex-post-only bubble-identification gang) and have “virtually nothing to do with U.S. monetary policy.”
Reporters let him get away with that? Last month, Dudley had his head handed to him by an audience in Queens, New York. When he tried to tell a group of ordinary folks inflation was under control because technology prices continue to fall, members of the crowd asked him when he last went grocery shopping.
What’s more, Dudley’s view that commodity price increases aren’t the Fed’s doing runs counter to the Fed’s stated intentions for QE2. In a Nov. 4 op-ed in the Washington Post, Bernanke outlined the channels through which the Fed’s bond purchases would operate. One was through higher stock prices, which would increase consumer wealth and trigger spending.
Measure of Success
Success! The Dow Jones Industrial Average is nearing a three-year high, up almost 25 percent since Bernanke first hinted at QE2 in late August.
Surely Dudley understands that commodity speculators aren’t immune to the same incentives -- zero-percent interest rates -- that encourage investors to move out the risk curve.
The Fed should be careful what it wishes for.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)
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