Friday, August 04, 2006

This Business Cycle is Over

[I wrote this last night, when I was in a bolder mood, perhaps, and when the unemployment rate was 0.2% lower than it was this morning. After today's employment report, perhaps the Fed will pause, if only because there is evidence that the hard landing is already beginning to play itself out. But FWIW, here it is.]


Yes, the Fed will raise interest rates this month, and yes, there will be a recession, or at least a severe slowdown that nobody will mistake for a soft landing.

Having thought this through, I realize that the Fed has no wiggle room. Financial markets may have confidence in the Fed, but it’s not the financial markets that the Fed needs to convince. After the price increases that have happened during the past few months, if Bernanke wants to keep the inflation rate below 2% for the rest of his term, he has to say to companies like Procter and Gamble, “Don’t you dare pull this crap again!” He has to make them regret raising prices. If the slaves are to learn to obey, at least one of them must be publicly whipped. And the only way the Fed can conduct a public whipping is by whipping the whole economy until it bleeds. (Whether the NBER subsequently decides to apply the term “recession” is really not much of an issue.)

There is a loophole, however. It’s a loophole that I personally would be willing to apply if I were in Bernanke’s position. (Of course, if I were in Bernanke’s position, my inflation target would be a bit higher than the 1%-2% range conventionally attributed to Bernanke and others at the Fed – but that’s another story.) The loophole is this: you are permitted to raise prices if all you’re doing is passing through cost increases that result from supply shocks outside the control of domestic firms and workers. But there are a couple of reasons that Bernanke won’t apply this loophole. First, with the unemployment rate comfortably below 5% and nominal wage growth finally accelerating, Bernanke will not be willing to assume that the price increases resulted from supply shocks. Second, with corporate profits already at a record, US firms can (collectively, though not in all individual cases) afford to absorb the supply shocks: you don’t get to raise prices just to maintain profit margins that are (on average) already high by historical standards.

So the Fed will keep raising interest rates until one of two things happens: the inflation rate comes back down or the economy buckles. Both will happen eventually; the latter will probably happen first; indeed, the signs could be in place before the subsequent Fed meeting. Meanwhile, however, it will not do simply to hope that the tightening so far has been enough (even though, in my opinion, it has). The slowdown needs to be a virtual certainty. The newly employed slave driver cannot risk being unintentionally lenient.

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24 Comments:

Blogger TStockmann said...

Department of naive questions:

Since the effects of the last 1-3 rate hikes have arguably not had their full effect and

Bernanke reported favors explicit inflations targets, then

why wouldn'y the most prudent step to pause in rate hikes at the next meeting in view of prior rate hikes and other economic indicators and state specifically
that if the next reported rate of [the favored indicator] exceeded 2%, this would occasion another 25 basis point rise, and if it exceeded [this amount] would result in a 50 basis point - or better - rise, all barring some other catastrophic problem. Complete transparency on the next two Fed meetings, with a firm anti-inflation commitment although not a permanent and rigid inflation target.

Fri Aug 04, 12:34:00 PM EDT  
Blogger knzn said...

TStockmann, I think the only thing standing in the way of your suggestion is Fed politics. That kind of explicitness is too much of a break with current practice. Unfortunately, the need to take baby steps may turn out to have very unpleasant consequences in this case.

Fri Aug 04, 12:42:00 PM EDT  
Anonymous Anonymous said...

knzn, I know I have tried this out before but I would love to know your qualified opinion on the recent book Macroeconomics: Imperfections, Institutions et Policies (OUP, 2006)? Pleaseeeee

Fri Aug 04, 04:36:00 PM EDT  
Blogger knzn said...

I'm not familiar with that book.

Fri Aug 04, 06:51:00 PM EDT  
Blogger true dough said...

Oh, the US!
With their “Scary Monsters” and their “whippers”!
I greatly enjoy your commentary on several levels.
(Why aren't you working for the Economist magazine?)

Sat Aug 05, 09:44:00 AM EDT  
Blogger spencerengland said...

Not counting "pass-through" is just another way of allowing the inflationay "spiral" to get started. We talk about how inflation excluding this or that is not bad. But for someone who lived through the 1970s it sounds very very familiar. To put it in perspective, the current inflation rate is almost exactly the same as it was in 1971 when Nixon imposed price controls.

Sat Aug 05, 12:41:00 PM EDT  
Anonymous mvpy said...

"The loophole is this: you are permitted to raise prices if all you’re doing is passing through cost increases that result from supply shocks outside the control of domestic firms and workers."

What if they rise prices in response to worker demands for greater compensation. Remember, they might raise prices before they grant wage increases; so price increases might come first, esp with staggered contracting and all that. But, I think the big issue here, as you allude to, is for Bernanke to prove he's made of steel - a veritible "economic macho man" (to parahprase Arnies phrase).
Oh, knzn, youd prob be interested in Robert Halls revisionist work on the nairu, potential etc - its seems relevant to some of your posts.

Sat Aug 05, 01:34:00 PM EDT  
Blogger knzn said...

Spencer, In accordance with the argument I made earlier, I don’t think it matters what you count, provided that you are adamant about stabilizing the part you do count. In other words, if you make a credible promise to stop the spiral at some well-defined point in the chain, then the spiral never gets started. The problem now is that the point of stopping is not well-defined. It’s worth noting, though, that, unlike the 70s, the benefit of price increases today seems to be going entirely to capital and not at all to labor. If you define the target as unit labor costs, as some research suggests is appropriate, then there is no evidence of any inflation problem. However, that may change on Tuesday morning.


(Just for the record, the 24-quarter linear-weighted moving average of the growth of log unit labor costs is 1% as of Q1 2006. In 1971 it was over 4%.)

Sat Aug 05, 01:58:00 PM EDT  
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