Martin Feldstein: The Fed's Difficult Task

Martin Feldstein joins Paul Krugman, Robert Reich, Brad DeLong, and Nouriel Roubini with worries about an upcoming recession, but nevertheless argues that the Fed should remain hawkish and focus primarily on inflation concerns. He's willing to accept the chance of a slowdown now from another rate increase to avoid the need for an even bigger slowdown in the future to eliminate rising inflation:

The Fed's Difficult Task, by Martin Feldstein, Commentary, WSJ: A soft landing is a natural aspiration for any central bank confronting an unacceptably high rate of inflation. For today's Federal Reserve, that means bringing inflation down to less than 2% without the fall in output and employment that would constitute a recession.

The Fed governors and Reserve Bank presidents appear to believe this will happen. Their "central tendency" economic projections ... state that ... inflation ... will decline from ... 2.9% ... in the most recent quarter to between 2% and 2.25% in 2007, presumably on its way to Ben Bernanke's "comfort zone" of 1% to 2% in 2008. They project this to occur with real GDP growing above 3% and the unemployment rate remaining under 5%. ...

Although this optimistic outlook is possible, experience suggests that it is unlikely. A mild slowing of economic growth is generally not sufficient to reverse rising inflation. That generally requires a sustained period of excess capacity in product and labor markets, with GDP growth falling significantly or even turning negative.

The Fed's projected combination of strong growth and declining inflation requires either a rise in the rate of productivity growth that slows the rise in unit labor costs, or some favorable spontaneous decline of the external drivers of inflation ... Neither seems likely. Productivity growth appears to be slowing, and external drivers are pointing to a continuation of high or rising inflation. ...

Taking the new GDP estimates into account is likely to lower the calculated productivity growth rates [further] and cause estimated unit labor costs to have risen faster than 3% in the most recent quarter. There is no reason to anticipate a favorable productivity surprise of the type that contained inflation in the 1990s.

The rapid rise in the overall cost of living creates wage pressures that make it harder to limit the rise in unit labor costs. The CPI in June was 4.3% higher than a year ago. Since wages and salaries have not kept pace, real wages were actually declining over the past year. That came to an abrupt end in June when they jumped at a 5.7% rate.

The external drivers of inflation imply that actual inflation is likely to rise even more rapidly... The doubling of the price of oil is being reflected in transportation costs and in the costs of ... petrochemical inputs. The gap between the sharp rise in real-estate prices over the past few years and the much smaller rise in rents is now causing a catch-up in rents... The decline of the dollar in the past year, and its likely further decline in the year ahead, will boost the prices of imports and of domestic goods that compete in global markets. ...

But while a decline in the core inflation rate may not be compatible with the FOMC's "central tendency" growth projections, the interest rate hikes of the past two years could soon cause a significant and sustained economic slowdown, bringing down future inflation without the need for further rate hikes. Although it is too soon to tell, some FOMC members may oppose a rise in the interest rate at tomorrow's meeting because of this possibility...

The consequences of the past interest rate hikes are difficult to predict. The fall in the real level of house prices has caused residential construction to plummet... The combination of lower housing wealth and a sharp fall in mortgage refinancing may cause the household saving rate to return to a positive level, bringing down consumer spending. Business expenditures on equipment and software slowed sharply in the most recent quarter. So a much sharper slowdown than the central tendency forecasts is certainly possible.

While this risk provides a rationale for a pause at tomorrow's meeting, it would be wrong to focus just on this downside risk. The probability that inflation will rise above the FOMC forecast is at least as great. The unemployment rate of 4.8% still represents a tight labor market. Waiting for more data before deciding to raise rates is not costless. If the Fed does not act and core inflation continues to rise, expected inflation may rise further. Higher expected inflation would cause faster increases in wages and prices. If the core PCE inflation rate rises above 3% in 2007, it would take a very substantial slowdown and a large loss of GDP and employment to bring it back under 2%.

In assessing the current interest rate decision, the FOMC members should recall that during the Volcker and Greenspan years the Fed pushed the fed funds rate to 8% above the concurrent rate of CPI inflation in the early 1980s, to 4% in 1989 and to almost 3% in 2000. That measure of the real fed funds rate is now less than 1%.

The Federal Reserve has a difficult task ahead. It is understandable that it would like to achieve the soft landing of low inflation with continued solid growth. But that may not be possible. And if the Fed wants to convince the markets that inflation will be contained in the future, it must show that it is willing to take the risk of tightening too much.

I hope we don't talk ourselves into a recession, and further rate hikes won't help on that front.

Comments

[ljm]

Convincing people to live within their means and learning to be savers in a time when they can find "savings accounts" that pay a better interest rate through CDs and some other vehicles seems like the smart thing to be talking about these days. If we don't help people learn to manage their own debt and of course our national debt, the threat of recession seems like small potatoes in terms of what is to come. Then there's the Conservative Nanny State Dean Baker writes about that we also need to do someting about to fix our economy. I've actually read that billionaires are buying property in New Zealand and rural areas of Argentina preparing for the time the income disparity here promotes greater violence and people start living in armed camps as exist in South Africa. This is nuts.

[hj]

"...billionaires are buying property in New Zealand and rural areas of Argentina preparing for the time the income disparity here promotes greater violence and people start living in armed camps..."

You're sure this is why they are buying stuff like that? Why not a couple nice villas on the Riviera or in Bermuda? Wouldn't that be more comfortable?

[Spectator]

Bernanke is about to show his true colors. He'll be cricified in about a year for lacking a backbone and being a financial industry patsy. That's when it'll be clear that inflation is out of control - we aint seen nothing yet.

Can't believe there are fools that think Bernanke is an inflation fighter? The man has no understanding of the value of money. And all savers will pay the price.

[slink]

god bless uncle milty
he shows his cards

"unit labor costs" vs labor productivity

only if the nominal wage creep equals or falls below
productivity gains
is he happy

ie
inflation like commodity prices (oil)
that goes to wind fall profits of scarcity
in a rising marginal cost production sector

well thats spontaneous rationing
thats to stimulate supply increase blah blah blah

but the peculiar commodity set
we call
wage laborers .....

nope they're diff
wage labor by policy design
must never get a scarcity premium
even after 30 years of stagnation and share decline

so ...induce a recession remove the scracity

[slink]

btw

he gives a crystal clear picture of the "drivers"

"The external drivers of inflation imply that actual inflation is likely to rise even more rapidly... The doubling of the price of oil is being reflected in transportation costs and in the costs of ... petrochemical inputs. The gap between the sharp rise in real-estate prices over the past few years and the much smaller rise in rents is now causing a catch-up in rents... The decline of the dollar in the past year, and its likely further decline in the year ahead, will boost the prices of imports and of domestic goods that compete in global markets. ..."

i like the windfall profit on exports as the dollar falls

but this is not a self sustaining process

its a price wave or series of price waves hitting the system that build in no change in the long run core rate

what uncle milty can't show

is how this can set of a 70's profit wage spiral
in a global system except where the traded products sector gives some price room
a higher dollar doesn't
but regardless
the job market itself remains the key

is there evidence of demand for labor tightness ???

i don't see it and even if we had some lets see it a while

this policy of pre emption
better safe then sorry

is played out at the exspense of the games small fry

not the corporate owners
who are far better positioned to absorb
any remotelt possible nominal wage rise surprise
after two decades of rising profits and asset values

[Robert]

Slink...

That aggregate US demand is greater than means seems evident. That we've reached the tipping point of "G's" accumulated indebtedness has also reached consensus. More of the same seems likely to continue to fuel asset prices and depress real wages further thus expanding both wealth and income inequalities.

But the fundamental issue - is the USA bogarting- remains. In any event it is already to late to dissuade the masses from day-trading, real estate speculation, and other feedback loops in response rapid changes in asset prices. Adjusting the price of money - while eventually effective - is the cowardly approach to the problem of excessive demand. Surely fiscal policy - dramatically higher marginal rates at upper levels and various windfall asset/profit taxes coupled with [burden-sharing but behaviour-shaping] consumption & energy levies would "fix" the problem. While both may "fix" the problem, only fiscal policy can address the issues of fairness with which you are rightfully concerned.

[knzn]

Taking the new GDP estimates into account is likely to lower the calculated productivity growth rates [further] and cause estimated unit labor costs to have risen faster than 3% in the most recent quarter. There is no reason to anticipate a favorable productivity surprise of the type that contained inflation in the 1990s.

Feldstein should know better than to estimate the expected growth rate of unit labor costs based on one quarter’s result. Unit labor costs grew by nearly 8% in Q4 2004, but they have grown at a rate of less than 1% in subsequent quarters (not counting the most recent that Feldstein cites, and for which the first official productivity data will be released tomorrow).

There may in fact be reason to anticipate a favorable productivity surprise. (See Brad DeLong’s work on the topic.) In any case, even anticipated productivity growth will be fairly high. The question is what compensation will do. It rose fairly rapidly, in nominal terms, in the latest quarter, and I would attribute the increase in unit labor costs to that compensation growth, not to a productivity slowdown. In one reasonable scenario going forward: (1) real compensation continues to grow very slowly and (2) prices of volatile commodities stabilize. In that case unit labor cost growth will continue the distinctly non-inflationary pattern that it has exhibited up to the first quarter of this year.

Feldstein apparently buys one of the alternative scenarios, in which either (1) rapid nominal compensation growth persists or (2) commodity prices continue to rise. Given the evidence that we have for a slowing labor market, and given that commodities are traded in speculative markets that should already be anticipating future prices, I’m not inclined to anticipate either of these scenarios.

(And see my own most recent posts, which are coincidentally on the topic of unit labor costs.)

[slink/js paine]

hell i thought i was reading friedman not feldstein

same team different position

cousin marty not uncle milty

and i take back my lead

usually
marty plays it super sly

and if i'd read more carefully i'd see his finger prints

knzn hits the bull's eye

"Feldstein should know better than to estimate the expected growth rate of unit labor costs based on one quarter’s .."

he does know better...

its one example of marty playing
his nasty fast shell shifting

this is the truth:

"reasonable scenario going forward: (1) real compensation continues to grow very slowly and (2) prices of volatile commodities stabilize. In that case unit labor cost growth will continue the distinctly non-inflationary pattern ..."

and
the only reasonable scenario

till some one demonstrates
how price makers are facing
either a sudden burst
of wage up pushing jobsters
and astonish us all
or that the firms themselves
are in a mad frenzy of bidding up
wage offers at the margin
and granting equalizing increases
to their in place staff

a tall order i'd say....

needless to say
its right to wack
the quarter bounce in productivity

but marty is building a case here
t'is
advocacy not science

the man is not my type
of anything worthy of praise

whereas uncle milty
--not his horror of a wifely unit --
has a certain admirable zeal .....

[slink/js paine]

robert

we may not fully agree here

i see no reason to try solving our trade imbalance by
a serious economy wide slow down

i see plenty of room for fiscal action
to avert such a general recession

this i feel confident about :

the dollar needs to fall
---rapidly if possible ----
against many major emerging currencies

and in the interim
we need to demand
emergency import restraints
out of china et al
like the japanese more or less agreed to
in the late 70's
on whatever we still produce domestically
i'm thinking stuff
ranging
from car parts
to fishing reels

fiscal stimulus will be doubly needed
if firms slow investment
in p and ei

who knows
they may even take
a header for a few quarters

i'd recommend
a dramatic
tax burden shift
off sub 100k payrollers

to compthe spending loss
from
the house as atm shut off

and i'd move that tax share
onto high net worth
asset holders

this redistribution of the burden
will produce
a sustainable non borrowed
household
effective demand spurt

------------------------------
ps

asset prices to me are frankly
another guys problems

i see my view determined by
job opportunity changes
and the rate of increase
in hourly job take home pay

for a quick fix i'd suggest a huge
federal take over
of educattion costs

say daycare funding for
under grade one kids
age
3 thru 5

[Movie Guy]

Mark Thoma - "I hope we don't talk ourselves into a recession..."

We're well beyond that point.

Many news media columnists and econ blog rants have not backed off on the complaining of this economic recovery from Day One.

Besides, the encouragement of Fed representatives, like Greenspan, all but guaranteed that a growing number of households would anchor into other than fixed interest mortgage loans which fueled the housing pricing and construction explosion.

Interest rates are not the primary problem. They're not that high, whether for consideration by businesses or consumers. Study the Flow of Funds data again.

The problem, of course, is that many households are sitting on high mortgage debts and those monthly bills are stripping away the households ability to spend monies on other services or finished consumer goods. Add to such consideration the growing inflation costs households are facing on energy and food purchases, the same cost increases that the CPI glosses over, and you have a recipe for recession. Meanwhile, real wages, real compensation, and median income are declining.

While consumer credit (separate from mortgage debt) is not outside of historical norms as a percentage of total household debt, it's clear that consumers have buried themselves in service costs as opposed to continuing to ramp up expenditures for consumer goods. But no one has been willing to discuss this point.

Our problems are larger than the forthcoming recession.

[Yartrebo]

ljm: You're right on the money. What the Fed needs to do is contain lending and borrowing, which is another way of saying that the Fed needs to reduce the money supply. All the Fed rate hikes in the world aren't going to do a thing if the money supply keeps going up at double digit rates.

Forcing people to put 25% down on any purchase (but primarily aimed at houses, cars, and department store goods) would be very effective, and interest rates could stay reasonable meaning that debt laden people aren't hit too hard.

[hj]

Roubini paints a picture of dark days ahead, with copious detail:

http://www.rgemonitor.com/blog/roubini/139867/

[vincentm]

I cant say I understand people who expect the fed to fight the rising price of oil. Inflation caused by exogenous factors is not something the fed should focus on. Quite on the contrary the fed needs to lower rates to compensate for higher price of energy.

[Movie Guy]

vincentm,

Lower the rates? How much? One percent won't make a much of change in consumer and business buying habits, not at current low interest rate levels.

Businesses are not complaining about business loan rates. These are moderate interest rates based on historical averages. Businesses are in good shape, including their portfolio loans.

Households are being told to save money, so why would the Fed want to send them back to the banks and other financial institutions for more equity loans? Or watch them rack up more consumer credit in addition to mortgage debt?

Are consumers and households really crying wolf about interest rates? Do you have any recollection of interest rates in the '60s or '70s?

[dj]

Who really believes the inflation rates produced by an entity that has a strong incentive to skew the numbers? SS is tied to the inflation rate. Hence, it is under-reported. Businesses like this also. Wage increases are usually tied to the CPI. Inflation has been upon us for years, but now it's out of control. It was in double digits in real estate, health care and education and now it's in food and energy. Inflation makes the saver a fool and rewards the borrower. Americans aren't any different than anyone else. We'll repeat rewarded behavior. Our systems rewards debt. The CPI needs a major overhaul by a group not funded by the US government.