Dollars and Jens
Tuesday, July 06, 2004
Interest rate policy — where I see the economy going
I've recently — particularly the past week and a half — been indicating here that, while I think the fed should raise rates, I'm in no hurry to see them rise too quickly. While current rates are not neutral, and probably distort the economy in ways that aren't good in the long term, the labor market is still weak enough (and the economy over-adapted enough to low rates) that we should wait for stronger evidence of incipient inflation before braking too enthusiastically.

Apparently Bruce Bartlett thinks we should brake harder yesterday.

His arguments about higher commodity prices have been made throughout the ages by Kudlow, and they seem vaguely plausible to me; on the other hand, they've been predicting inflation for a while now, and I'm starting to wonder how long the lag is supposed to be. (If high commodity prices are supposed to cause inflation, it seems notable that labor is a much bigger part of most producer costs than are commodities.) It is my understanding that The Chairman does monitor the gap between the rate on the inflation-protected bond and the traditional, unprotected bond; that has indicated inflation in the neighborhood of 2% for quite a while. (TIPS yields have been going up over the past few months, just as nominal rates have.)

His comment about housing prices was, in fact, addressed here last week; his heart doesn't seem to be in it, and for approximately the reasons I gave. And I'm willing to spot him his reservations about more purely Keynesian arguments that inflation can't be happening because the economy has "unused capacity"; indeed, I've heard indications that much of the measured unused capacity is, in fact, obsolete capacity, and probably won't be used.

What really jumps out as a flashing red beacon, though, is this off-the-wall comment:
Just between Tuesday and Wednesday of last week, the yield on this bond fell from 4.69 percent to 4.59 percent because the Fed reduced inflationary expectations by tightening monetary policy.
This is exactly wrong. Everyone who wasn't working for Washington Mutual knew the fed would raise rates; the few people who thought there would not be a 25bp hike were expecting a 50bp hike. What surprised people was the statement, which tamed market projections of future fed hikes. Long-term rates came down because the fed statement was dovish, not because it was hawkish. (The rates have, in fact, dipped below 4.5% since the unemployment report came out.)

I have to admit that this may be an "anchoring" bias, but I just don't see record corporate profits as sustainable. The scenario I'm still carrying around with me is that the job market continues to improve, eventually it accelerates to the point where income growth exceeds GDP growth (which it still hasn't over any few months), companies start bidding against each other for workers, and most of the cost eats into corporate profits for several months before the companies have any general success passing cost hikes on to consumers.

Sustained core CPI increases would, of course, have to change my mind. If we don't see that, increased unit labor costs that aren't accompanied by falling earnings would concern me; even as if corporate earnings do fall as a result of wage pressures, that becomes the time to worry about inflation coming further out. Until then, a move toward a more neutral rate can be done very gradually, allowing fallout to occur at a rate where it won't threaten the ongoing recovery.

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