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.