Stay Away from the Fan

If we lived in my fantasy world where the Fed targets unit labor costs and everybody knows it, we’d be fine – and due for some more substantial rate cuts. Not that I would have the Fed react dramatically to the latest dip in unit labor costs – which is only one quarter out of many and, after all, could be revised away. My fantasy Fed might take the latest labor cost report as a minor reason to congratulate itself on past policy actions, what with earlier seeming evidence of an acceleration in labor costs turning out to have been falsely alarming. But as for cutting rates, the Fed has plenty of other reasons: a deepening financial crisis that threatens to affect the real economy; a deepening housing recession (depression?) that threatens to spill over to the rest of the economy; a substantial decline in labor demand that has finally begun to show up in the unemployment rate. If labor costs were the target, the Fed could respond to all these concerns and shrug off the other news: the fastest increase in commodity prices since the 1970s. If everyone knew the Fed were targeting labor costs, then workers wouldn’t expect pay increases to compensate for rising energy costs and the like, and the Fed could ease without risking losing credibility or creating an inflationary spiral.

If we lived in my other fantasy world where the Fed follows a backward-looking Taylor rule, we’d be doing OK too – and still (in my opinion) due for some more rate cuts. Although there is inflation on the horizon, the Fed could use (and could already have used) the low reported trailing inflation rates as an excuse to cut rates. By the time the commodity price increases found their way into core inflation, hopefully the financial crisis would be over, and, with any luck, the Fed would re-tighten at just in time to prevent a boom.

But in the real world, Fed policy is judged not by unit labor costs or by its adherence to a backward-looking rule but by outcomes in the core inflation rate. (I’m thankful at least that I live in the USA, where we know that smoking cigarettes causes cancer and targeting headline inflation causes unnecessary recessions and booms.) If the Fed lets the core inflation rate rise for any reason, that will lead people to question the resolve of its still relatively new chairman. And workers, facing a reasonably healthy economy, will feel entitled to wage increases to offset their rising cost of living. And businesses, facing that same reasonably healthy economy and a seemingly friendly Fed chairman, will see no reason not to raise prices enough to preserve their record profits and compensate both for increased energy and materials costs and for increased wages. Unfortunately, the only way for the real Fed to maintain its credibility today is by keeping the economy weak and risking recession, so as to damp any economic optimism, which, in combination with rising non-labor costs, would result in a higher core inflation rate.

So here we are, people. Just over a month ago, I insisted that the s___ was not yet hitting the fan, but it looks like I spoke too soon. The fan is running. The s___ is flying. Just get out of the way.