Thursday, August 17, 2006

In Defense of Labor Cost Targeting

A week or two ago, I made the apparently heretical suggestion that the Fed should target unit labor costs. Brad DeLong picked it up with a link to my subsequent post. Several objections have been raised, and I want to deal with those objections here.

The main objection, coming from Dean Baker and kharris, is essentially – to use my own earlier words – that the unit labor cost series is “subject to revision, and volatile from quarter to quarter.” As I agued in the original post, “This would be a big problem for an intermediate indicator, but not so much for an ultimate target. The important thing is that the long-term trend be predictable…” Unit labor cost depends on compensation rates and productivity. I think the Fed is already pretty good at forecasting the trend in compensation rates. Productivity is more difficult, but this is a problem even if you target inflation.

Granted, the long-term trend in labor costs is probably not (contrary to what I suggested in the original post) as predictable as that of inflation. This is a disadvantage, but it is (I would argue) far outweighed by the advantages, particularly the relative robustness to the effects of supply shocks. Under a price-based (rather than labor cost-based) targeting regime, a huge adverse import price shock (such as a major dollar crash or sudden increase in oil prices) would virtually force the Fed to induce a recession. (Indeed, the Fed may have induced a recession – yet to fully materialize – in response to the more gradual oil price increases of the past few years.) Under a labor cost-based regime, the price shock could feed through to consumer prices without necessarily having a large effect on economic growth or employment. In principle, why should a scarcity in one commodity (such as oil) automatically induce a scarcity in another commodity (money)? Doesn’t a currency “backed by the productivity of the US labor force” inspire more confidence than a currency “backed by the promise of price stability”?

As my thinking has evolved, I would also suggest that a labor cost target should have the form of a “price rule” rather than a “growth rule.” That is, the Fed should explicitly try to correct deviations from trend rather than establishing a new trend when the old one is broken. The “price rule” approach helps with the data volatility problem by letting the Fed allow temporary deviations while credibly promising to maintain the longer-term trend.

Another objection, coming from an avowed non-expert:

When I hear "targeting unit labor costs" what I also hear is "we don't want workers to make more money, ever." To a lay observer like me, the Fed (and its counterparts in Europe) seem determined to prevent workers' wages from rising.

Actually, when I wrote the original post, I asked myself, “Would this regime discriminate against workers?” Would it automatically “take away the punch bowl before workers get to drink?” I think the answer is no. A labor cost target would allow workers to take full advantage of productivity gains, something they have apparently not been able to do under the current regime. Of course, firms could take back that advantage by raising prices, but I’m not sure that’s such a bad thing. In a sense, the current regime has allowed firms to undertake “stealth price increases” by keeping wages down. Under the current regime, the Fed is like, “Oh, hey, we’re just controlling inflation,” and firms are like, “Oh, hey, we’re just trying to keep costs down.” Under my proposed regime, firms would have to own up to the fact that they are grabbing a bigger share of the pie. If there are legitimate economic forces that are granting them that bigger share, then so be it, but let’s bring this process out into the open air of consumer markets rather than burying it in the back room of compensation determination.

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