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Five Things You Need to Know: Roots of Inflation; Put Your Root Down; NAIRU; Right Back Where We Started; And Speaking of Inflation Expectations


What you need to know (and what it means)!


Minyanville's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. Roots of Inflation

The Wall Street Journal this morning has a front-page story about how the Fed is "rethinking" the root cause of inflation and its ties to unemployment.

  • Although getting played as a dramatic ground-shifting view on inflation, today's article is actually a follow-up piece to a recap of Fed Chairman Ben Bernanke's monetary policy report before Congress earlier this month.
  • "Federal Reserve officials appear to believe unemployment can go lower than they previously thought without generating inflation," the Journal's Greg Ip wrote almost two weeks ago.
  • Today he writes, "[The Fed now] believe it takes a far bigger change in unemployment to affect inflation today than it did 25 years ago. Now, when inflation fluctuates, they are far more likely to blame temporary factors, such as changes in oil prices or rents, than a change in the jobless rate."
  • What's the upshot? What, if anything, does this mean, and why should we care?
  • According to Ip, this "new view" explains why the Fed stopped raising interest rates last summer while core inflation was rising, and why the Fed is reluctant to cut rates now even though it sees inflation edging lower over the next two years.
  • But is this really a dramatic shift in Fed thinking? Let's take a closer look.

2. Put Your Root Down

In a simplistic sense, the view of the Fed, and many economists, has long been this: when unemployment goes down, inflation tends to go up, and when unemployment goes up, inflation tends to go down. The reality, however, is that this relationship hasn't behaved as expected for years.

  • This view is grounded in a relationship shown by something called the "Phillips Curve."
  • Back in the late 1950s, economist A.W. Phillips found that there appeared to be a necessary and fixed trade-off between unemployment and inflation.
  • The illustration of this relationship became known as the Phillips Curve.
  • The fiscal and monetary policy implications of this were that any attempt by a government to reduce unemployment would lead to increased inflation.
  • Back in the day this notion seemed simple and useful enough - at least until stagflation arrived, breaking the unemployment-inflation relationship.
  • In fact, it was Milton Friedman who, in order to save the Phillips Curve, showed how it could be "adapted" to inflation expectations; hence, the "Expectations-Augmented Phillips Curve."
  • This adjustment was to allow for the fact that not all inflation expectations are created equal.
  • In other words, there are both "short-run" inflation expectations and "long-run" inflation expectations, and as a policy maker dealing with inflation management you don't want to lump them all in one big basket.
  • Anyway, the bottom line in this Expectations-Augmented Phillips Curve s that a "tight labor market" tends to be associated with an increase in inflation.
  • The problem, however, is what constitutes a "tight labor market"?
  • Going back to Federal Reserve Chairman Bernanke's monetary report to congress he said, "[m]easures of labor compensation, though still growing at a moderate pace, have shown some signs of acceleration over the past year, likely in part the result of tight labor market conditions."
  • Unlike the WSJ story, that suggests the Fed really is up against inflationary unemployment pressures, right? What gives?
  • This leads us directly to today's Number Three...NAIRU...


Going back to the Feb. 16 Wall Street Journal article that kicked this whole thing off, "Fed Suggests It Is Loosening Employment-Inflation Link," Greg Ip noted that Fed economists now think the public's expectations of inflation based on past inflation data are playing a greater role... seriously.... in future inflation, than unemployment.

  • A day after Fed Chairman Bernanke's testimony before Congress the Cleveland Fed issued a brief note titled, "The Cost of Labor as an Inflation Indicator."
  • Labor compensation growth has risen over the past couple years from about 3 percent in mid-2004 to nearly 5 percent at the end of 2006, the note said.
  • "Moreover, labor productivity growth has moderated significantly from highs in 2002-2004 to roughly 2 percent. These two trends have pushed up unit labor cost growth substantially over the past couple of years, from about a 1-1/2 percent decline to about a 3 percent rise by the end of 2006," the note added.
  • Pretzeling to come up with an explanation for how to reconcile this with the Fed's policy, the note concluded: "It could be argued that the rising unit labor cost growth measure may exaggerate the potential inflationary pressure in the economy."
  • In order to understand this, we need to understand something called NAIRU.
    NAIRU is an acronym for "non-accelerating-inflation rate of unemployment."
  • This is the so-called "optimal rate" of unemployment.
  • So, when the unemployment rate is below NAIRU, then we have tight labor market conditions, lifting demand for workers and pressuring wages and employment costs.
  • That's the theory, anyway.
  • The only problem with NAIRU is that the Fed itself isn't exactly sure of its value in forecasting inflation.
  • How do we know this? Because the Fed said so... 10 years ago, back in 1997, in a San Francisco Fed letter titled, "NAIRU: Is it useful for monetary policy?"
  • So where does all of this leave us in this Fed and the public's inflation expectations game?

4. Right Back Where We Started

Actually, it leaves us right where we started before all of this "shifting inflation policy" began.

  • This result - the failure of NAIRU as an inflation forecasting tool - is intuitive if we think about it. In fact, the notion that most mainstream economic thinking suggests - that strong economic activity somehow causes inflation (a general rise in prices of goods and services), is what is counter-intuitive.
  • It doesn't matter what the rate of employment is if every increase in expenditures is supported by corresponding production.
  • As Frank Shostak noted in a piece written nearly seven years ago, overheating can only occur when the money supply is increasing.
  • In other words, and what is our most oft-repeated theme, what the Fed fears most is the absence of public inflation expectations.
  • The news today is what the Fed fears second: that people may one day wake up and recognize how their standard of living is being undermined by a central bank that continues to pump money into the economy eroding their "wealth."
  • That is why the public's inflation expectations are today far more important to the Fed than unemployment or labor costs.

5. And Speaking of Inflation Expectations

The National Association of Business Economists released their latest survey showing, among other things, that inflation expectations are "stable."

  • While we're on the subject of inflation expectations, this should be good news for the Fed.
  • The NABE's most recent survey shows panelists continue to expect lower inflation this year with, core inflation largely stable.
  • Other tidbits worth noting from the survey:
    - The U.S. economy appears to be transitioning to a sustainable growth path.
    - Housing is likely to remain the primary force dampening growth this year, particularly in the first half.
    - The panel continues to see a further gradual weakening in the dollar both against the euro and a broad basket of currencies.
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