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Inflation: The Phantom Menace

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Inflation: The Phantom Menace

by Jared Bernstein

The current economy looks great from the perspective of America’s working families. Unemployment is the lowest its been in three decades, inflation is low and stable, and living standards, after stagnating throughout most of the recovery, are finally rising.

But, as is all too often the case at the Federal Reserve, what’s good news to most of us is bad news to the nation’s most influential bankers. Fed Chairman Alan Greenspan has warned the public that he fears the economy is growing too quickly, and, when the Fed meets at the end of this month, they are expected to try to slow things down by raising the target federal funds rate by 0.25 percent.

Greenspan and company are not simply being grinch-like. I have every reason to suspect they favor prosperity as much as anyone; in fact, their deft handling of monetary policy, including three rate decreases late last year, helped create today’s robust economic climate. So what exactly is the problem they are trying to fix?

It’s the fear of future inflation, with the emphasis on “future.” As noted, current inflation is running at an annual rate of about 2 percent, well below a level that would concern even the most hawkish central banker. But Greenspan’s oft- expressed concern is that the tight labor market will, sometime down the road, cause the economy to overheat, as scarce workers make ever-increasing wage demands. Thus, he plans to act preemptively.

There are three compelling reasons why he should reconsider.

First, the benefits of full employment are only beginning to ripple through the economy, and need more time to work their magic. The wage of the typical, or median, worker was actually falling throughout most of the recovery. Only when unemployment started to really tumble around 1996 did the real (i.e., adjusted for inflation) median wage start to regain lost ground.

By the first quarter of this year, it finally reached its pre-recession (1989) peak. And while much has been made of the fall in the overall unemployment rate, the real story is the decline in the jobless rates and the resulting gain in the wages of minorities, who have been major beneficiaries of the recent labor-market tightening.

The second reason the Fed shouldn’t raise rates is because productivity is growing fast enough to handily absorb the wage gains that are occurring.

Productivity-output divided by hours-measures the efficiency with which our labor force is converting inputs into outputs, and it has been acceleratingabout a percent above trend since 1996. This means the economic pie has been expanding faster of late, allowing for larger “slices” in the form of real wage increases, without price pressures. In addition, most economists predict that productivity growth will remain strong in this quarter as the growth in overall hours worked has slowed significantly, while output shows no signs of lagging.

Third, the Fed does not need to act pre-emptively to slow economic growth. In earlier periods, Fed officials believed that interest rate policy operated with a so-called lag: rate hikes put in place today would not be operative until many months hence. Thus, in order to slow price pressures that might be over the horizon, the Fed believed it had to strike in advance.

But recent evidence suggests this is no longer the case. This shouldn’t be a surprise. Statements by the Fed are scrutinized daily, and their recent rate hikes were absorbed almost instantaneously by the financial markets, and only slightly less quickly by the housing market. If prices were to begin to grow more quickly, it is well within the Fed’s power to slow the economy and avoid accelerating price growth.

At any rate, an upward shift in the price level is unlikely in the near term. Productivity growth would have to slow, which, as noted above, is unlikely to occur in the next quarter. Also, recent corporate reports show that firms have been expanding their profit margins in the last few quarters. This adds another buffer. In today’s competitive product market, before pushing wage increases forward to consumers, firms are more likely to tap their profits.

If I’m wrong, and the Fed deemsed the higher level of inflation unacceptable (and there is no obvious reason why our economy could not grow prosperously with inflation slightly ahead of its current rate) it could then intervene to reduce the rate of growth. Until that time, the benefits of sustained full employment-, from growing labor market opportunities, to flush public coffers, to falling crime rates, are too precious and have been too long awaited to be unnecessarily sacrificed.


Jared Bernstein is an economist at the Economic Policy Institute. He specializes in labor markets and wage inequality and is a co-author of State of Working America 1998-99.

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