Paul Krugman: The Phantom Menace

Paul Krugman wonders why the Fed is so concerned with inflation when wage growth isn't keeping up with productivity:

The Phantom Menace, by Paul Krugman, Commentary, NY Times: Over the last few weeks monetary officials have sounded increasingly worried about rising prices. On Wednesday, Richard Fisher, the president of the Federal Reserve Bank of Dallas, declared that inflation "is running at a rate that is just too corrosive to be accepted by a virtuous central banker."

I'm worried too — but not about recent price increases. What worries me, instead, is the Fed's overreaction to those increases... Discussions of inflation can be numbingly arcane — are you a core C.P.I. type or a trimmed-mean P.C.E. person? But the real issue is whether there's a serious risk that inflation will become embedded in the economy.

The classic example of embedded inflation is the wage-price spiral — better described as wage-price leapfrogging — of the 1970's. Back then, whenever wage contracts came up for renewal, workers demanded big raises, both to catch up with past inflation and to offset expected future inflation. And whenever companies changed their prices, they raised them by a lot, both to catch up with past wage increases and to offset expected future increases.

The result of this leapfrogging process was that inflation became a self-sustaining process, feeding on itself. And ending that self-sustaining process proved very difficult. The Fed eventually brought the inflation of the 1970's under control, but only by raising interest rates so high that in the early 1980's the U.S. economy suffered its worst slump since the Great Depression.

Fed officials now seem worried that we may be seeing the start of another round of self-sustaining inflation. But is that a realistic fear? Only if you think we can have a wage-price spiral without, you know, the wages part.

The point is that wage increases can be a major driver of inflation only if workers consistently receive raises that substantially exceed productivity growth. And that just hasn't been happening. In fact, the distinctive feature of the current economic expansion — the reason most Americans are unhappy with the state of the economy... is the disconnect between rising worker productivity and stagnant wages...

Nor is there much sign that things are changing on that front. ... But if wage pressures are so moderate, where's the inflation coming from? The answer is soaring oil and commodity prices.

It's true that some widely used inflation measures, like so-called core inflation, strip out the direct "first-round" effects of rising energy prices. But there are still indirect effects, which usually take some time to show up in the data. Much of the recent rise in core inflation probably represents the delayed effect of the big run-up in fuel prices a few months ago. And unless something else happens to drive up oil prices — like, to give a wild example, a military strike on Iran — inflation will probably subside in the months ahead. ...

It would be an exaggeration to say that there's no inflation threat at all. I can think of ways in which inflation could become a problem. But it's much easier to think of ways in which the Federal Reserve, wrongly focused on the phantom menace of a new wage-price spiral, could be slow to respond to bigger threats, like a rapidly deflating housing bubble.

So I don't fear inflation nearly as much as I fear the fear of inflation. And I wish the Fed would lighten up on the subject.

For more on this point, see Fed Watch: Ascendancy of the Hawks

Previous (6/12) column: Paul Krugman: Some of All Fears
Next (6/18) column: Paul Krugman: Class War Politics

Update: Robert Reich joins the chorus of voices wondering if the Fed is overreacting to the threat of inflation:

There's No "Inflation Genie.", by Robert Reich: I've spent much of the day on the phone, talking with financial reporters about inflation and the "consensus" view on Wall Street that Bernanke and the Fed must raise short-term rates again in order to stop the inflation genie from getting out of the bottle. Wall Street is wrong. It's still haunted by the double-digit inflation of the late 1970s. It forgets the double-digit depression of the 1930s.

The fact is, this economy is not at all like the economy of the 1970s. Labor unions don't have nearly the power they did then to demand wage increases. Big companies don't have nearly the power they did then to raise prices. Globalization and computer software have radically increased wage and price competition. So the inflation genie won't get out of the bottle. The price rises we're seeing now are due to energy and raw-material commodity price increases, which are NOT being driven by excessive demand by American consumers and NOT being driven by inflationary expectations. ...

In addition, productivity has grown enormously in the US during the last five years. Wages have not. Wages comprise 70 percent of the costs of business. One last thing: There's still lots of unemployment in the US. The payroll survey shows only small increases in hiring. A smaller proportion of adults are employed now than in 2000. The ranks of people too discouraged to look for work are very large.

So forget the inflation genie. Worry more about the 1930s. I don't mean to suggest a full-fledged depression is on the horizon. But I do worry that the economy is slowing. Consumers are reaching the limit of their capacity to go deeper into debt. Their one cash cow -- the value of their homes -- is in poor shape. ... If the Fed keeps raising short-term rates we're heading for a major downturn.

Me thinks Bernanke wants to show Wall Street he's a tough guy. But tough guys often over-estimate the importance of acting tough.

In the end, the people who get clobbered when the Fed raises rates and the economy slows are those at the end of the job line -- people who need jobs, or are in low-paying ones. They're the first to be let go. At a time when the number of working poor in America are already ballooning, and the ranks of the impoverished are growing, it's not only economically wrong for the Fed to go on raising rates. It's ethically wrong.

Update: Greg Mankiw links Steven Ceccetti who has a different view on the underlying inflation trend.

Comments

[Movie Guy]

I see Paul's so-called "phantom menace" at the gas station and grocery store every week. And the Fed isn't even focused on those two sources of price pressures.

[jm]

Perhaps the wage-deflation pressures of offshoring and Asian mercantilism are so great that inflation in non-Asian goods and asset prices is inevitable if money supply grows fast enough to just keep wages stagnant, and, conversely, wages must must fall if money growth slows sufficiently to keep the overall price level within Fed targets.

[gordon]

jm is on the money. To say what is probably the same thing, the "inflation" which Krugman calls the "phantom menace" is really uncontrolled money supply growth, the effects of which have been canalized into asset and oil price rises - and kept out of wages.

[bullbust]

The cat's out of the bag. Expectations cannot be jawboned anymore - because people see through it now. The Fed can talk till it's blue, but CPI inflation is felt and realized by anyone. Fed talk will not influence expectations anymore. LT interest rates will rise, whatever the Fed does.

[lonesome moderate]

I find the John Berry column (Can you Hear Me Now? What?) to be more convincing than Krugman's. Berry's argument is that the Fed understands full well what Krugman says above, but is being pushed to raise rates anyway by jittery "financial markets".

If Berry is right then it would appear that the core competency of a fed chief is not economics but babysitting the financial markets, whoever they are. It would appear that they have been badly shaken by Bernanke's attempts to use plain English in describing his policies, and he'll only be allowed to stop raising rates after he masters the art of Delphic Greenspanese. Hope it happens soon.

[thedart]

As I follow the direction of monetary, fiscal, political, economic and social policies of the American government, I shudder at the tremendous problems that this current and future generations of Americans will face.

Firstly, the instant gratification syndrome through plastic cards is such a pervasive curse on American basic work ethics. Americans do not face a "twin deficit" - they face a TRIPLE DEFICIT! The current account, the trade account and the personal bank accounts of each American. And the hallowed seers in Washington continue to pander to their electorate and start blaming the Japanese (at the Plaza Accord), now the Chinese and in a few years later, the Indians for their currency manipulaton practices. Hey, no one in these countries or any other ones is pointing a gun at each American to consume their products beyond what they can afford!!! Why don't we look at ourselves in the mirror and ask if we are digging our own graves and blaming others for supplying the earth.

Secondly, I'm not aware of any greater ill will that America has generated amongst the international community currently compared to the past. America's foreign policy since the Bush administration had alienated itself with many of its previous allies and of course, with many other countries because of its unilateral arrogance and double standards. It's time for Washington to seriously reflect on its foreign and economic policies with the rest of the world. Empires rise and fall - America is not immune if it continues to disregard the external sentiments of both its allies and not so friendly nations.

Thirdly, the standard of education in the US has dropped so tremendously. I watched with tremendous embarrassment when some Americans interviewed on TV could not point out where New York is on the map. And they don't know the history of their founding fathers. If American education continues in this downhill slide, its technical and tactical superiority in defence will be a mirage one day.

Fourthly, the state of the social welfare and healthcare system is abyssmal. If politicians (and their electorate) continue to take soft options, I can imagine how bleak it will be for retirees and future generations having to fund their own and present retirees' welfare and healthcare needs.

So, let's stop putting all the responsibility on the Fed Chairman in stabilising inflation but individually take responsibility for our own future by making the right consumption and voting decisions.

The Dart

[nyuk]

Maybe next year when our union contract expires, I'll push for a no-raise contract, just cause I'm a swell guy who doesn't want to contribute to an inflationary spiral. But I'm not going to count on much support from my union brothers and sisters.

I keep hearing the Bush administration say how strong the economy is. With all the tending it seems to need, it seems a lot like a delicate flower, ready to wilt from the slightest bruise. And you know who gets hurt the worst? The rich. After being so cheery for so long, they'll have to experience just a twinge of what the rest of us have been feeling. And it will be a shock to their systems. Poor little rich people.

[anne]

Inflation through the last 12 months is 2.4%, which given the continuing energy price increase and well growing economy is remarkable and promising though I would prefer to have stronger wage growth. There is no reason to believe however the Federal Reserve will not be able to readily limit inflation from here.

[James Kroeger]

It is a mystery to me why most economists accept the inanity of using a single inflation number when pondering the wisdom of different inflation strategies. Inflation is spoken of as though it affects everyone in the same way, but it doesn't.

It is not only possible for different income groups to experience different rates of inflation, it is also possible for one income group to experience accelerating inflation while another income group experiences disinflation, or even deflation. That is essentially what has happened over the past couple of decades as the Republicans have cut taxes for the wealthy at the same time that outsourcing and cheap imports have put downward pressure on both the prices and the wages that affect lower class citizens the most.

It is possible to measure the different rates of inflation that different income groups experience by putting together a number of different "market baskets" that are appropriate to different groups of income earners. The higher your income bracket, the greater the weighting of certain spending categories, like 'purchases of real assets.' What this kind of data would reveal to us is that when the Republicans start throwing money at rich people as is their wont, it ignites a strong round of inflation within their income group that is ultimately reflected in the higher prices paid in the stock, real estate, and art markets. It costs more to be rich than previously.

So what sense then does it make to refer to THE Inflation Rate? Inflation is not a phenomenon that has some kind of 'blanket effect' on the fortunes of all income earners. People in different income groups are going to experience different inflation rates, i.e., different rates of change in the "cost-of-living." Shouldn't that matter to us when we are trying to formulate policy options?

The index number that everyone uses to measure Inflation, the CPI, is weighted to to reflect a fairly narrow cross-section of America's income earners. Let's ask the Bureau of Labor Statistics to calculate a number of different inflation rates that affect different income groups, based on different market baskets of purchases. Price increases in assets markets need to be included in the calculation (properly weighted) because such purchases are an important part of a rich person's standard of living.

The single index number provided by the BLS hides a lot of important information within it that policy makers need if they want to formulate sound policy. If we could stop generalizing about inflation when it is not appropriate to generalize, we might actually be able to start having meaningful discussions about the so-call evil of Inflation. Perhaps we'll discover that it doesn't seem quite so important for us to protect creditors from the harm they'd suffer from a 7.5% CPI inflation rate, when the actual rate of inflation they are personally experiencing is much, much higher.

[calmo]

My goodness.It's ethically wrong. Bring out the whips then and lets give them all a good lashing.
There are ethics committees that look after this sort of nonesense people. And that is why Delay was retired after a life long career of sordid undertakings. (You figure there are no ethical standards for this remark and that my professional stature is at risk in making such a bold statement?) Justice and even ethical justice was done and is done --no matter what Tom The Huggable says. It even appears to be done should it turn out that it was not --as Tom The Wicked says.
Competence is not enough for Reich. He demands exemplary conduct, not merely law-abiding behavior but ethical performance. [That is why there is the Sally Anne Can on the way in to those Fed meetings people --gentle reminders that the poor need some consideration, and do they get it...]
The standards for Fed performance just got cranked up a notch or 2, no? According to Reich the maestro may have been good, but not really. Not Good, as if it were the ticket that got you past the Pearly Gates.
(I'm busy deciding whether Greenspan's performance was more or less exemplary, you? Those speaking engagement fees following his retirement as a public official left a bad taste, a slight odour, a little something less than exemplary...especially after all that talk about the poverty of those trust funds.)
The excruciating demands of some ethical standards may be unbearable. The cost of being Good may not be worth the price.
Is the demanding Reich asking too much people?
Goodness gracious, if we missed this message in our education will raising this question Is it ethical? now, put us back on the right path?

[anne]

James, I agree, there is every reason to attend to a range of price indexes for economic analysis, but for monetary policy there needs to be a limit to the range unless policy is to be designed to control specific product or asset prices. Dealing with health care costs or tuition costs or energy or housing prices or slow rising wages is not directly for the Federal Reserve.

[anne]

James, of course, really wishes what I wish and what we cannot have now, an intelligent fiscal policy that gradually limits market distortions, such as by openly designing a long term conservation and alternative energy policy.

[Movie Guy]

James Kroeger - Nicely done.

It's clear that it wouldn't be particularly difficult to separate the effects on the ultra rich, rich, and those households earning less than $80K or $60K. As those income levels represent a sizeable portion of the population, someone in the news media, academic, or policy could "push" for that breakdown.

The Fed and other concerned agencies have the capacity to do exactly what you're saying. They're using survey data, for Pete's Sake.

[Movie Guy]

anne - "James, of course, really wishes what I wish and what we cannot have now, an intelligent fiscal policy that gradually limits market distortions, such as by openly designing a long term conservation and alternative energy policy."

I don't know if James wishes for the same thing, but I do know that the information you appear to be seeking is readily available from this Administration as it was from the previous Administration. Perhaps more detail that you would care to absorb. There are pages and pages of such detailed information.

[Michael Cain]

It is a mystery to me why most economists accept the inanity of using a single inflation number when pondering the wisdom of different inflation strategies. Inflation is spoken of as though it affects everyone in the same way, but it doesn't.

Indeed. A study several years ago in Colorado found that a household at the poverty level spent some 16% of their income on energy -- versus only 5% for a household at the median income level. Which no doubt contributes to the Administration's lament about why do so many people think the economy is doing badly? Core CPI at the median is a poor measure of the effects being experienced by the low-income population.

[billy]

>So what sense then does it make to refer to THE Inflation Rate? >Inflation is not a phenomenon that has some kind of 'blanket >effect' on the fortunes of all income earners. People in different >income groups are going to experience different inflation rates, >i.e., different rates of change in the "cost-of-living." Shouldn't >that matter to us when we are trying to formulate policy options?

Yup. The 1% and the slow crawl to 5% has been a transfer of wealth to those who own finacial assets and homes, as those assets inflated wildly. This was the Fed's own grand experiment of the trickle-down theory. In an abstract sense, a helicopter drop would have been vast better than this asset pumping - at least it would have been more equitable.

And all those economists who benefitted from the liquidity binge and asset inflation sit and chant - lquidity is good, investment is good, yeah everything is fine - while vehemently making hot air about how bad it has been for low income people.

At lest Cecchetti is honest enough to pose it thus-

"As for OER itself, I firmly believe that some measure of the cost of owner-occupied housing belongs in the price index used for monetary policy purposes. We should not just get rid of it. Furthermore, looking at these data, there are two choices: Either the OER distorts the CPI, or it doesn't. If it does, then along with claiming that measured inflation is currently too high, you have to accept that measured inflation from 2001 to 2004 was too low. That is, there was never a deflation scare. Instead, policy was much too loose following the end of the 2001 recession."

[BAWDYSCOT]

What do you guys think about letting citizens use their 401ks to pay down household debt tax free without penalty? It seems to me it is worthless to save your whole life and still have credit cards to pay off after you retire. This also might get the middle class to realize we need to save more and use our credit cards less.

[James Killus]

Let me suggest a hypothetical.

Suppose there were two countries, in some sort of neo-colonial relationship. The rich country follows something like the German model, good social benefits, primarily tied to corporate employment, high capital stock, high education levels, and so forth. The poorer country has some social benefits, a social security system, a health care system that is overstressed and that doesn’t cover everybody, stagnating wages, and its capital stock is almost entirely colonial, i.e. the other country owns almost all of it.

Both share a common currency, and on a cash flow basis, the poorer country is sending a lot of cash to the richer country.

Monetary policy from the central bank clearly affects both countries, but both countries can have different fiscal policies. Moreover, cash flows between the two countries can dominate their local monetary policies. The cash flow from the poor country to the rich country has, in fact, produced a liquidity trap in the poor country. By the same token, the same cash flow has created a high degree of liquidity in the rich country, but, because the rich country imports much of its goods and services, it hasn’t seen much CPI inflation. Rather, it has had a series of asset price bubbles.

Now actually I’m talking about a single country here, the United States. The rich country consists of those who have substantial capital assets, and/or are well-situated in the corporate hierarchy. The poor country is low and middle income wage earners without major assets, whose primary asset, in fact, is their share of the social security system, and perhaps a low equity house in a “non-bubble” area like the mid-west.

The major cash flow is the Social Security surplus, which continues to divert enormous sums to the general fund, and the general fund pays out much of its cash to corporate contractors. Also whenever a member of the low income class buys something, a portion of that goes to the rich class, in the form of profits or the wages paid to the affluent class who manage the enterprise.

I think that, with only a few exceptions, “the poor country” has been in a liquidity trap for the past 25 years. CPI price inflation occurs when some of the liquidity that washes over the “rich country” manages to leak into “the poor country.” It is then immediately stamped down by raising interest rates, which pulls yet more money from low income workers (who tend to be debtors). Since high income liquidity primarily affects asset prices, and since asset price inflation is not considered inflation, monetary policy does not react.

Economic “growth” has been confined to the high income group, but since this tends to consist of nominal asset growth, it is not clear to what extent the growth is real. It may be largely an artifact of asset price inflation whose effects have been confined to a part of the economy that doesn’t show up in inflation estimates.

In short, the economy may actually be experiencing stagflation, but that is masked by asset price inflation. Any attempt to turn that nominal growth into actual consumption would trigger CPI inflation, which would immediately be met with interest rate hikes, which further hurt the real economy of low wage earners, but which does little to correct the underlying fiscal malady.

[James Kroeger]

anne:...but for monetary policy there needs to be a limit to the range unless policy is to be designed to control specific product or asset prices.
I think the goal of monetary policy should be to prevent 'hyperinflation' while at the same time not allowing the economy to experience anything other than a modest-to-slight Labor Shortage. Maintaining the Labor Shortage is important because that is the only time when unemployment is eliminated, the production of wealth is optimized, investment (future real growth) is optimized, and Poverty-As-We-Know-It is eliminated. Those are simply too many beneficial optimums for us to brush off in the name of "price stability."

Once the Monetary Autority has allowed [government induced] aggregate spending to grow to the point when this Labor Shortage 'realm' has been achieved, it should then seek to prevent a continued acceleration of price increase rates. It might even be able to keep 'The Inflation Rate' that we currently use in single digits most of the time.

To me, no other monetary policy is sound, or rational, or even ethical, as Bob Reich would say.

[anne]

Yes; the Federal Reserve has a mandate for looking to control general inflation and spur employment, and that with the help of sound fiscal policy was just what was done during the last Administrion, but core consumer inflation which ran at 2.4% these last 12 months, will not be allowed to go much higher and there is no possibility that inflation here will be allowed rise to 10%.

[prock]

So is Krugman suggesting that the Fed lower or stall interest rates in an effort to ease the collapse of the housing bubble? How does this affect the asset bubble? Hasn't Krugman been arguing that the ultralow interest rates of the past few years (negative real interest rates) has contributed to a delayed recession. Shouldn't he be cheering the Fed on for finally making the US take its medicine?

And if the Fed should be concerned about the fact that wages haven't been rising (since when has the plight of the working man been part of the central bank's charter), aren't they doing the right thing by fighting asset inflation by killing speculation?

I respect Krugman's ideas in general, but I think this argument is contradictory to his previous statements.

[anne]

Paul Krugman has been consistent in arguing for low short term interest rates when the economy was recovering sluggishly from a recession. That strong demand for housing and gains in housing prices were a dramatic help in the recovery, worked out perfectly. Should there be scattered markets in which housing prices are higher than some analysts are comfortable with, the Federal Reserve is not a fixer of asset prices. The last thing households need is a significant decline is housing demand and prices along the coasts.

[js paine/slink]

the real brake out should be
the trinity

product asset and wages
each has a varaible rate with regard to the others

the long gabble about asset bubble pops
was a side of the mouth discussion which at least
mentioned the "inflation rate "of assets

since wages are really what any descent corporate dominated fed would be after

thats really the final control target

but to make that patent would be unseemly

so we'll get an endless re run of household product inflation talk
which is as bobby the good sez
is less then 30% non labor in a closed system

commodity prices are really rent runs
so lets carve that out especially since over half of that rent is paid to domestic corporate ops

ah how i run on

btw

like my new more real name ???

[Movie Guy]

anne - "That strong demand for housing and gains in housing prices were a dramatic help in the recovery, worked out perfectly. Should there be scattered markets in which housing prices are higher than some analysts are comfortable with, the Federal Reserve is not a fixer of asset prices. The last thing households need is a significant decline is housing demand and prices along the coasts."

The regional and general runup in housing prices fed by the lax policies pushed by the Fed represent one of the biggest disasters in recent history. And the process is far from unwinding.

The Fed and Administration were able to conveniently mask the issues creating the economic problems in the USA with the housing game, and its execution was certainly less than honest. Recall Greenspan's words to the general public.

There is no excuse for the U.S. Government to have been instrumental in creating the housing distortion as the "easy out" vehicle for recession recovery. That the U.S. trade policies which are driving the ongoing low median and real wages were masked with the bogus method of recovery is paramount to simple if not gross negligence.

Where are we now - we're still stuck with that mess. Housing prices are far ahead of the pricing norm for valuation. Property taxes rocketed as well. Neither approach is sustainable against the general wage base. Similarly, the volume of home equity loans also masked the truth about real wage and broader compensation levels.

To now give the Fed and Treasury a pass on the obvious errors of recovery is absurd. Had the recovery been handled differently, the bulk of tax breaks and credits would have flowed to lower income households. Instead, we simply provided them with the means to play Casino Housing with highly inappropriate personal cheerleading from Greenspan and others. It was absurd. Pure and simple.

We gave the public a "sugar high" and little more.

[Per Kurowski]

If Krugman is right about his fears then what we mortals would have to grapple with is not only the fear of inflation but also the fear of not having adequate combatants. I believe, until further notice that the Fed is just as aware and worried about all the concerns raised by Krugman.

That said, and a bit in line with Stephen Cechetti’s discussions on the theme of the Owners' equivalent rent of primary residence component in the CPI, we should never forget that when charging against the inflationary beast, we are in fact only charging against a man made CPI index muleta, that we believe indicates where the bull is, but, in a world going through so many changes, who could really swear to that?

Yes CPI has been low but we all know that this is not only the result of monetary policies, and pressure from some CPI components that until now might have been sort of lucky laggards might explode in our face. From a strict erosion of monetary value point of view, something that is much more than solely a cost of living issue and looking at the price of many assets, no one could convince me that inflation is low or that it is only a temporary oil thing.

Since an increase in protectionism could wipe away all what has made it possible for the Fed to be loose handed over the last years, then perhaps Krugman, and others, could do better using their fear of fears on others than the Fed.

And, come to think of it, oil inflation is far from over, as now the US needs more than ever, to top up the prices at the pump with some heavy duty consumption taxes… to help take care of all the other problems before the rates are raised, not by Bernanke, but by some foreign financiers, frightened out of their wits.

[anne]

"And, come to think of it, oil inflation is far from over, as now the US needs more than ever, to top up the prices at the pump with some heavy duty consumption taxes…"

Huh??? War, no problem, so let's tax tax tax comsumption :)