Tim looks at the likely direction for Fed policy:
Inflation Concerns Growing, But Don’t Look For a Rate Hike Yet, by Tim Duy: Earlier this week I wrote:
The Fed has a duel mandate of price stability and maximum employment. Protecting the external value of the Dollar is not the mission of the Fed until the Dollar falls so low as to be relevant to it legal mandate.
The next day Fed Chairman Ben Bernanke said:
We are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations and will continue to formulate policy to guard against risks to both parts of our dual mandate, including the risk of an erosion in longer-term inflation expectations.
The Greenback’s slide is now a clear source of discomfort for the Fed, suggesting that additional cuts are off the table. Persistently high headline inflation, and the recent spike in near term inflation expectations, are warning signs that most central bankers do not take lightly. Still, it would be premature to conclude that a rate hike is coming soon. Today, Bernanke contrasts the current situation to the 1970’s:
From the perspective of monetary policy, just as important as the behavior of actual inflation is what households and businesses expect to happen to inflation in the future, particularly over the longer term. If people expect an increase in inflation to be temporary and do not build it into their longer-term plans for setting wages and prices, then the inflation created by a shock to oil prices will tend to fade relatively quickly. Some indicators of longer-term inflation expectations have risen in recent months, which is a significant concern for the Federal Reserve. We will need to monitor that situation closely. However, changes in long-term inflation expectations have been measured in tenths of a percentage point this time around rather than in whole percentage points, as appeared to be the case in the mid-1970s. Importantly, we see little indication today of the beginnings of a 1970s-style wage-price spiral, in which wages and prices chased each other ever upward.
The Fed used to take comfort in the stability of inflation expectations in general. The rise in near-term expectations is something of a slap in the face, so policymakers more explicitly focus on long-term expectations. But as noted by many – see Paul Krugman here – the real key is if wage setting behavior begins to follow inflation expectations. Until that happens, the Fed will not sacrifice growth by raising rates, nor should we be particularly concerned about runaway inflation. Across the Curve summarizes the implications for the Treasury market:
I want to return to the Bernanke speech which has received much attention because he spoke about “significant” inflation. I think the Bloomberg headliner writer is short financial assets of every ilk as the speech was mostly upbeat. I think the reaction to the speech is about positions. If traders truly believed that the Fed was hyperventilating about inflation, then the 2 year note should have been sold hard. Instead it is the best performer on the list. That indicates to me that the street is long the longer maturities and the price action forced out many players. If the street truly believed that the Fed was about to respond to some inflation pressures ,then the curve should have flattened as investors would shun the 2 year sector.
At the same time, they will be hesitant to cut rates, especially with a stabilization in the Dollar and commodity prices (notably oil). No reason to pull the tail of an already aggravated tiger. The real test, however, of any commitment to hold policy steady will come only after another spasm in the financial markets. Although the Fed is hoping for continued stability, the monoline insurers remain on life-support and there is a persistent fear that Lehman will go the way of Bear Sterns. Would the collapse of either trigger a rate cut? Recent history of the Fed argues for such a move. Let’s hope we don’t have to learn the answer to the question.
A final thought – I have spent a lot of time thinking about what could cause wage setting behavior to follow inflation, and identified two risks. The first is that labor constraints in expanding sectors are significant and reaching a critical point. Dean Baker points us to a New York Times article on the labor shortage in Iowa, and Baker notes that the obvious solution to the shortage is to pay higher wages. The second risk is a policy response to discontent among the electorate. In April, Paul Krugman wrote (italics added).
A major reason we’re feeling so down now is that for working Americans the boom never did come back. Job creation in the post-2001 recovery was pathetic by Clinton-era standards; wages barely kept up with inflation. Instead, corporate profits and the incomes of a tiny elite surged — sucking up so much of the economy’s growth that only crumbs were left for everyone else….
Some of the causes of poor economic performance since 2000 are probably beyond any administration’s control. Raw materials were cheap in the 1990s, but in the years ahead the rise of China and other emerging economies will place increasing pressure on world supplies of oil, copper and so on, no matter what the next president does.
But reinvigorated regulation could help restore confidence to the financial system. A return to pro-labor policies could help raise real wages...
Funny thing is it appears if we want to pursue Krugman’s policy of real wage acceleration, we will have to push up wages to compensate for the recent acceleration in wages, which sounds an awful lot like embedding higher inflation expectations into wage expectations. I imagine it would be something of a delicate task to shift compensation power to labor while convincing firms not to respond to that shift by hiking prices. The risk is that guaranteeing against a 1970’s repeat requires accepting a lower standard of living for the many Americans who have already seen virtually no gains since 2000, and this will become increasingly politically unpalatable in the months ahead. I am at a loss to see the expenditure switching policies that smoothly redistribute income (profits to wages) with out boosting aggregate demand in an environment that is already potentially inflationary. Suggestions?