What would happen if the Fed were targeting unit labor costs?

…as it should…

For one thing, people like me wouldn’t be so panicked about stagflation right now. When you hear about the CPI and the PCE deflator, things look bad, but when you look at unit labor costs, it’s just another ordinary day. I reserve judgment, though, on whether we’ll be panicked tomorrow morning, when the second quarter productivity report comes out.

Also, people like Brad DeLong wouldn’t be so worried about import prices. Import prices don’t directly influence US labor costs, and presumably, if the Fed made a credible commitment to stabilizing labor costs, then workers would see that it is not in their interests to demand pay raises to compensate for import price increases.

Incidentally, the Fed might have started to tighten more quickly during the early part of 2005, after a couple of unpleasant unit labor cost numbers came out. In retrospect, that would have been a good time to tighten. However, the Fed might also have recognized that those numbers were just temporary problems. The subsequent inflation problems seem to be for different reasons (rising oil prices, mostly).

To put things in perspective, here is a chart of smoothed unit labor cost growth. (I used a logarithmic growth rate and chose an exponential smoothing parameter to maximize predictive accuracy at a 4-quarter horizon.)



Historically, things start to get ugly in 1969, with a breakout above 3%; they get uglier in 1974 with a breakout above 5%, and uglier still in 1979 with a breakout above 7%. Today, however, nothing unpleasant seems to be going on: this series remains near the bottom end of its historical range. (The situation may change tomorrow, but, given my smoothing parameter, the change is unlikely to be dramatic.) So, what would happen if the fed were targeting unit labor costs? Well, if the target growth range were 1% to 2% (as contemporary opinion suggests it might be), then we would congratulate the Fed for doing such a good job.