Sunday, August 06, 2006

Should the Fed Target Unit Labor Costs?

Yes, if you ask me. I would suggest using unit labor costs as the ultimate target of Fed policy, not just as an indicator to watch for signs of inflation. In fact, I think an explicitly announced long-term target might be a good idea (better than an inflation target).

Why should the Fed choose unit labor costs as a target?

1. It’s simple. There are no subtle debates required about things like “Should we include energy?” and “Should we exclude housing?”

2. It avoids wage-price spirals. When the spiral hits wages, it gets nipped in the bud.

3. It avoids “bad sunspots.” That is, it never gives reason to lose confidence in the value of money, since it ties the value of money to the labor content of goods and services. (Avoiding “bad sunspots” is the most basic rationale for having some sort of target in the first place.)

4. It achieves “greasing the wheels” (provided that productivity growth is consistently non-negative and the target growth rate for unit labor costs is positive). In other words, in most cases, it makes nominal wage cuts unnecessary and thereby avoids the situation where firms reduce employment because they doubt workers would accept such wage cuts.

5. It allows the Fed to accommodate external supply shocks, so that such shocks (hopefully) don’t produce recessions.

6. It allows the Fed to provide a stimulus to take full advantage during times of rapid productivity growth.

There are a couple of drawbacks I can think of, but they don’t bother me much:

1. The data series has unpleasant characteristics. It is reported with a lag, subject to revision, and volatile from quarter to quarter. 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, and in this respect, unit labor costs is probably no worse than any other series.

2. In the event of a persistent supply shock (such as the recent experience with oil prices, if that experience continues), this approach would allow persistent inflation. And my response is, “So what?” Inflation is mildly unpleasant, but the alternative of economic stagnation is highly unpleasant. On welfare grounds, it makes no sense to insist that the inflation rate always be low. If individuals are worried about inflation risk, they can buy insurance, probably at prices which (as suggested by TIPS spreads) would be very reasonable. (Of course, if such insurance is never offered, because there is no market for it, that just makes my point that inflation risk is not such a big deal.)

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