Caging the Inflation Hawks

As was widely expected, the high priests at the Temple of the Fed announced yesterday that they would hold the Fed Funds Rate (FFR) steady at 5.25 percent.

There are inflation hawks out there who will criticize the decision, but it's a good thing these hawks are keeping their claws off the pause. Neither the economy nor workers' wages need higher interest rates and slower growth right now.

Technically, the FFR is the interest rate the Fed charges to lend money to banks, but practically, it is the main lever by which they set the cost of borrowing throughout the economy. It's also a deeply scrutinized signal of where the Fed thinks the economy is, or should be, going. When they raise the rate, they're signaling their concern that the economy is overheating, and needs the weight of higher borrowing costs to slow it down. And visa versa -- lower rates are intended to boost economic activity.

By continuing to pause -- the FFR has been at 5.25 since June 29th -- the Fed is diagnosing the overall economy as "not too hot, not too cold," a kind of Goldilocks scenario. While Fed chairman Ben Bernanke, along with others on the interest rate committee, have expressed concern about inflationary pressures, their statement yesterday suggests that these threats are abating and inflation is heading toward their comfort zone.

Ben and co. made the right move (or lack thereof). Here are a few reasons why:

First, the overall economy is clearly slowing, with real GDP growth well below its potential (most economists place the economy's potential between 3 and 3.5 percent real GDP growth). Thanks to the housing slump and its attendant downsides (less activity in related industries and diminished housing wealth), real GDP increased at an annual rate of 2.2 percent in the third quarter. Forecasts for the current quarter are also below trend -- the Blue Chip forecasters (an average of many independent forecasts) expect 1.9 percent. Beyond that, the debate regarding growth next year boils down to whether the economy will experience a soft landing (continued below-trend growth) or a hard landing (a recession). In other words, the economic bicycle is already pedaling uphill; the last thing it needs right now is an even steeper slope induced by a Fed rate hike.

A big question for the Fed is whether this slowdown is reflected in slower inflation. The answer: yes. If you look at three month, annualized changes in the core consumer price index (the Fed prefers this measure, which excludes volatile energy prices), you find the following pattern:

Annualized 3-month changes, core CPI (source: BLS)

May-06 3.8%
June-06 3.6%
July-06 3.2%
August-06 3.0%
September-06 2.7%
October-06 2.3%

For a Fed banker seeking decelerating core inflation, what's not to like?

Second, as Economic Policy Institute economist Josh Bivens and I recently reported, lower inflation in recent months means that the real FFR has actually been rising, and it's the real rate that drives investment decisions. With the rate of inflation falling, the Fed actually needs to lower the FFR to keep the real rate from rising.

Third, and this one's closest to my heart -- and I suspect to yours too. After five years of a recovery uniquely rich in productivity growth and poor in real wage growth, low- and middle-wage workers are just starting to see some serious real gains. (It's true that thanks to the tight job market, nominal wages had been rising for a while, but energy-driven price growth swallowed up those gains and more until very recently.) On a yearly basis, the real wages of blue-collar factory workers and non-managers in services were up 2.4 percent in September and 2.8 percent in October; chances are November will show similar gains. Before that, this real wage series was down 1.8 percent off its peak in late 2003.

Only the most Scrooge-like Fed would shut down the party just when the working class got there. But of course, gains like these are exactly what make Fed-heads nervous. Bernanke himself recently warned that now that energy prices have moderated, his main inflationary concern is labor costs.

But the fact is that these real gains came wholly from slower price growth, not faster wage growth, so they're not threatening wage-push inflation. Nominal hourly wages have expanded at a year-over-year rate between 3.8 percent and 4.1 percent since the summer. And if you look at the same type of annualized three-month changes that we did above with prices, you see that hourly wage growth has decelerated in recent months, from 4.7 percent in August to 3.1 percent last month.

And let us not overlook the fact that firms' profit margins remain historically very high, meaning businesses could afford non-inflationary wage gains yet maintain solid, as opposed to excess, profitability.

All of these factors were well known to those at the Fed, and probably played a role in their decision to hold. (Big Ben himself, bless his class-warrior soul, has commented on the profitability point.) In fact, assuming these trends hold up, would it kill anybody over there to lower rates at the next meeting?

Stay tuned.

Jared Bernstein is a senior economist at the Economic Policy Institute and author of the new book All Together Now: Common Sense for a Fair Economy.

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