The Fed Must Teach Markets a Lesson on Inflation
Like a parent whose toddler thinks "no" means "maybe," the Fed must eventually prove that it means what it says.
Officials say the target of 2 percent inflation is "symmetric," meaning that modest, temporary deviations either above or below the target are acceptable. Investors and businesses don't believe them.
Markets assume that the Federal Reserve is bluffing, and that in fact 2 percent is a ceiling -- so that if inflation appears likely to inch above that line, officials will intervene to cool things down.
The only way for the Fed to maintain (or regain) its credibility is to stand by its symmetric goal -- allowing for deviations north of 2 percent, even though businesses and investors will get hurt.
With the Fed in a period of transition as some members cycle out and new members cycle in, its most interesting policymaker might be Governor Lael Brainard, who gave a speech this week about economic headwinds becoming tailwinds. Noting that inflation has been running below the Fed's target for years, she said that stronger economic tailwinds could help "re-anchor inflation expectations at the symmetric 2 percent objective." She's right to point out that stronger tailwinds could achieve this, because up until now the evidence is lacking that it has.
The reason it's lacking is that the most consistent theme in corporate America in early 2018 is rising input costs but sluggish price increases for consumers, resulting in tighter profit margins. The most recent example of this phenomenon was the discount retailer Dollar Tree, whose shares were down 16 percent on Wednesday after the company said wage and freight costs would eat into 2018 profits.
The Fed's Beige Book report, released Wednesday, showed multiple Federal Reserve districts noted this phenomenon as well. The Boston district noted tight labor markets and potential wage increases, but no contacts said they planned substantial prices increases. The New York district noted "input price pressures have intensified, while selling prices generally continued to rise modestly."
There are a couple reasons this pricing dynamic could exist, both suggesting the Fed needs to let the economy run hot. First is that there exist a lot of businesses without pricing power, businesses that might go away if the economy continues to run hot and wage and other input costs rise at an accelerating rate. These are the types of businesses that are supposed to go away as the economy gets hotter, allowing their employees to be bid away by higher-paying and more productive firms.
The second reason is that businesses don't believe the Fed is credible on inflation and are gaming the economic cycle. If you're a business that believes the Fed will always respond to full employment and 2 percent inflation by raising interest rates enough to cool down the economy and create a recession, then the proper move is to never invest in capacity or productivity growth when the economy is running hot -- why overpay for capacity you won't need after a downturn?
Similarly, you'd rather leave positions unfilled than raise wages to pay up for talent -- after all, in a downturn, you'll be able to hire those workers much more cheaply. And you won't raise prices aggressively and risk losing sales or market share, because in a recession once your costs fall you'll get your juicy profit margins back without resorting to price increases. Instead, you're free to ignore inflation pressures and stick to stock repurchases, letting the Fed handle inflation for you.
That works for investors, in the short term. But it's a problem for the economy, as it prolongs unemployment and distorts wages.
This is the mentality that needs to be conquered if the Fed truly wants its word to wield power in the economy. But it will come at a cost. The businesses that won't invest in capacity or production, or raise wages or prices, will find themselves getting squeezed in a frothier environment. Companies that underpay workers may find themselves with critical vacancies they can't fill, or unionization efforts that threaten their labor models. A failure to raise prices will eventually threaten the viability of businesses. A failure to invest in capacity or productivity growth will put companies at a disadvantage to their peers who do make these investments.
For years, the Fed's main task was supporting economic growth to get the labor market back to full employment. Finally, it has a choice to make, one that comes around only late in an economic cycle: let the economy run hot enough to keep businesses from gaming the system, or slam the brakes on the expansion and reward inflation skeptics once again.
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Philip Gray at firstname.lastname@example.org