Putting Inflation on the Back Burner

Slow growth and a slackening labor market are easing worries. So for the first time in years, the Fed must focus on its other mandate: maximum employment

Federal Reserve Chairman Ben S. Bernanke's one-paragraph reference to inflation at the end of his 3,700-word speech on Jan. 10 seemed almost obligatory. By contrast, Bernanke's words about the new risks to economic growth were surprisingly clear and forthright, making it evident that the Fed's concerns about prices have slipped a notch. If the latest gloomy growth forecasts are anywhere close to right, the central bank's apparent downgrading of its inflation worries is well justified.

The latest survey of economists by Blue Chip Economic Indicators expects growth to average 1.5% annually from the fourth quarter of 2007 to the second quarter of 2008, and many analysts think that's optimistic. The economy seems set to grow well below the roughly 2.5% pace needed to create jobs for all the people looking for work. That would guarantee a further rise in the jobless rate, downward pressure on wage growth, less purchasing power among consumers, and less pricing power for business.

The deteriorating outlook for the labor markets changes everything for the Fed. Most important, it removes the policymakers' chief inflation worry, "high resource utilization." That's Fed-speak for tight job markets. Back in March, with the jobless rate at 4.4%, the low point for this business cycle, tightly wound markets threatened to push labor costs higher at a time when productivity was growing too slowly to offset those additional costs. In the past, that situation has led to rising prices as businesses tried to maintain their profit margins by charging more.

Now, with unemployment up to 5% in December, job markets are loosening up, and cost pressures are easing. Hourly pay of production workers, which had grown at an ever faster pace during 2006, began to slow in 2007, and that pattern should continue. Already, unit labor costs, which take productivity into account and tend to correlate with long-term inflation trends, fell in both the second and third quarters, the first two-quarter drop since the last recession. At the same time, falling profit margins suggest little pricing power, a situation sure to continue in a weak economy. December consumer prices were tame, rising 0.3% from November and a modest 0.2% outside energy and food.

The Fed has also expressed concern over high energy and commodity costs. But commodities are very demand-sensitive, and a U.S.-led global slowdown will allow prices to ease. Further evidence of slumping U.S. demand showed up in the 0.4% drop in December retail sales, and businesses are pulling back. December manufacturing output was weak, and CEO confidence in the fourth quarter dropped to the lowest level since 2000, according to the Conference Board.

U.S. weakness is already starting to spill over to economies in Europe, Canada, Mexico, and parts of Asia. Even Chinese exports in the fourth quarter appear to have slowed from the third quarter. Cooler overseas growth is clear in slower U.S. exports from August to November. High oil and food prices themselves are part of the squeeze on global demand, as their downward effect on growth appears to be overtaking their upward pressure on inflation.

What the Fed cares about most in the price outlook is inflation expectations. The fear is that rising energy and food prices will cause businesses and consumers to anticipate higher inflation and build that expectation into the wage- and price-setting processes. That's what happened in the 1970s and '80s. However, there is no sign that is occurring or about to occur. Even after soaring oil and food prices in recent years, some measures of expected inflation are lower than they were two years ago.

Fading growth and weaker labor markets assure a much clearer policy message from the Fed in coming months. For the first time in years, the central bank must now focus on the other half of its dual mandate: to foster not just price stability but also maximum sustainable employment. Inflation fears aren't likely to stand in the way of tackling that goal.

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