September 8, 2015


Why the Fed Must Banish the 1970's Inflation Devil Before Raising Rates (Mark Thoma, 9/08/15, The Fiscal Times)
[I]n the face of such uncertainty raising rates too soon is potentially much more harmful than raising rates too late, so why not take a wait and see approach? 

The answer from the Fed is that there are long lags between the time policy is implemented and its impact on the economy, so the Fed needs to preemptively change policy well before evidence of rising inflation is present in the data. 

However, two factors work against this argument. The first comes from new research by Ekaterina Peneva and Jeremy Rudd of the Federal Reserve, "The Passthrough of Labor Costs to Price Inflation." This work finds that there is "little evidence that changes in labor costs have had a material effect on price inflation in recent years." They also review other research on this topic, and note, "The general conclusion that emerges from this literature is that there appears to be a break in the relation between labor costs and broad price measures, with changes in labor costs having little or no predictive power for price inflation after the early 1980s." 

Related: Muddled Jobs Report Leaves Fed in a Jam Watching Markets 

Thus, members of the Fed who remember the "cost push" inflation of the 1970s may be basing their policy conclusions on fears about pass through from wages to prices that are no longer justified by empirical results. In any case, the research supports a cautious approach to raising rates even if labor markets are tightening. 

And there is something else that has likely changed since the 1970s, the lag between changes in monetary policy and its impact on the inflation rate.  To explain this lag, macroeconomists use mechanisms such as the costs of changing prices, the cost of adjusting inventories, and the cost of adjusting the labor force that cause firms to spread the adjustment to shocks over time. 

Empirical work performed long ago found that the lags in response to monetary policy changes are, to quote Milton Friedman, "long and variable." But it's hard to believe that the lags have not shortened over time with advances in digital technology. Price changes no longer need to be calculated by hand, inventory management has improved by leaps and bounds, labor market insecurity has risen, and so on, and so on. The precise value of the policy lag is not known, it is very difficult to determine econometrically (especially when the structure varies due to technological change), but if the lags have shortened - and it's hard to believe they haven't - then the Fed can be more patient now than in the past. 

The inflation problems of the 1970s, the loss of Fed credibility that came with it, and the need to impose the Volcker recession in the early 1980s to bring inflation down to tolerable levels made an indelible impression on policymakers who lived through that time period. The Fed's trigger-happy response to any suggestion of an inflation problem is directly related to the desire to never let such an inflation outburst happen again. 

But it has been more than four decades since the beginning of the inflation problems of the 1970s, and the economic environment in which monetary policy operates has changed considerably since that time. Those changes support patience, particularly in response to increases in wages, wages that have been stagnant since the 1970s even as labor productivity has been increasing. 

Raising rates into the teeth of a deflationary epoch has caused the last three (or four, depending how you count them) slowdowns.  We don't need to repeat the same mistake.

Posted by at September 8, 2015 8:16 PM

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