Inflation: A Whole New Ball Game?
By Michael Englund
Score one for the markets. Wall Street got quite a boost on June 1 when Dallas Federal Reserve President Richard Fisher said in a televised interview that "we're clearly in the eighth inning" of the central bank's current cycle of interest-rate hikes. And he added: "We have the ninth inning coming up at the end of June…there is room to tighten a little bit further. Then we will see how we are standing against inflation."
Equity and bond investors cheered like a Yankee Stadium crowd anticipating a late-game appearance by Mariano Rivera. But at Action Economics, we have to wonder if Fisher isn't watching the wrong game.
On our scorecard, the first-quarter productivity report released June 2 loaded the bases for inflation, thanks to a surge in unit-labor costs. The productivity report revealed a huge gain in compensation costs in the 2004 fourth quarter (as revised) of 10.2%, followed by an impressive 6.3% rise in the 2005 first quarter.
This left unit-labor costs with a much more worrisome trend. The first-quarter gain was revised upward to 3.3% (median 1.9%), from 2.2%, while the fourth-quarter gain was quadrupled, to 7.7%.
The bottom line: The data support the view that underlying secular trends in productivity remain strong, though productivity has peaked on a cyclical basis. Unit labor costs are in the midst of a relatively large cyclical uptrend, despite the restraint provided by productivity. And the strength in labor costs adds some tension to the otherwise typical output/inflation trade-off "game" Federal Reserve policymakers are engaged in.
Until now, that game has been slow to develop. But with recent strength in commodity prices and output data, Team Inflation, though in the lead, doesn't have a huge margin for error.
If the new Dallas Fed President is already looking forward to the final at-bat, it may be that he's more focused on a different game: the "new paradigm" struggle between productivity and inflation. This contest was the frequent focus of prior Dallas Fed President Robert McTeer, and it's one in which accommodative Fed policy is consistent with low market yields and rapid growth in investment and productivity.
In this game, rapid output growth isn't necessarily inflationary, and so accommodative policy is desirable in the middle years of an expansion as long as inflation remains generally contained.
By those lights, the game at New Paradigm Field is being won by Greenspan & Co., as the Fed has succeeded in containing inflation pressure overall, despite eventual upside risk. And it appears clear that a near-term "pause" in rate hikes, with continued accommodative Fed policy, is a viable strategy.
While this particular game may not be quite in the eighth inning, as Fisher suggests, it's probably approaching the seventh-inning stretch. If that's the case, the Fed can enjoy the glory of a solid secular trend in productivity and output, and perhaps use the cover of perceptions of a "soft patch" in the manufacturing sector to resist market pressure to tighten rates further.
Ultimately, the outcome of the Inflation Series comes down to this: If Fisher and the rest of the New Paradigm club are correct, and productivity trends can continue their winning streak, the game is in hand. But if they don't, and commodity and wage-price pressures continue to trend higher, there will be no joy in Fedville -- or on Wall Street -- and the rest of the competition could turn into a real nail-biter.
Englund is chief economist for Action Economics