Will the Fed Hit the Brakes Too Soon?

Paul Samuelson, in a long ago policy debate, noted that a cat that jumps on a hot stove once never jumps on a hot stove again; of course, it never jumps on a cold stove either. Today, Samuelson’s image applies to the long running complaint that expansionary policies are courting dangerous inflation.

Apart from the years immediately following World War II, when wartime controls on wages, prices and production were lifted, the one notable period of inflation in the modern US economy came in the 1970s. CPI inflation reached double digit rates in the mid-70s and again in the late-70s and early-80s. After he was appointed Fed Chairman in 1979, Paul Volcker’s draconian monetary policy aimed at ending that inflation brought on the massive 1980-82 recessions. Nobody wants to repeat such an episode. But many fail to appreciate how little that period has to tell us about inflation risks in today’s economy.

The 1970s were a red hot stove in many ways. The Vietnam War had escalated defense spending in an economy already nearing full employment, bringing on a classic excess aggregate demand inflation. Most other industrial nations experienced similar booms. Labor unions dominated wage setting in the major industries and most wages were formally indexed to the CPI, assuring real wages would not be eroded in the years between wage negotiations. Thus, when the OPEC cartel was formed and quadrupled the world price of oil, this supply side jump in prices accelerated the ongoing wage-price spiral throughout the economy. The 1974-75 recession slowed this process. But when the Shah of Iran was overthrown by Islamic clerics in 1979, oil prices soared again, giving inflation a dangerous new boost.

Today’s economy could hardly be more different. Rather than operating on the margins of an extended period of excess demand, the US economy has been recovering only slowly from the Great Recession. And rather than riding an extended postwar recovery boom, most of the rest of the industrial world today is recovering from recession even more slowly than the US. There is no massive supply-side shock on the horizon remotely comparable in magnitude to the two oil supply shocks of the 1970s. Indeed the main impact of developments abroad has been the deflationary pressure of imports from China. Furthermore, structural changes have made the economy much less inflation prone. Large unions are no longer an important factor in wage setting and few wages are indexed to inflation. Most formal models of the macroeconomy allow for expectations of inflation to influence wage setting, but the form of that relation is controversial, and surely provides a looser link than the contractual indexing of wages that characterized the inflationary years.

Despite all these differences between today and the 1970s, most models of the inflation-unemployment relation still rely on econometric estimates that are driven almost entirely by the data from that one inflationary period. And these continue to drive the thinking of many observers about monetary policy. Some of these models suggest the inflation danger point is 6 percent unemployment, which would mean we are already there. Others suggest a danger point between 5 and 6 percent unemployment, which means we will be there soon if the recent improvement in labor markets continues. However estimates based only on data from more recent decades do not support such results and, in fact, provide no reliable estimates for this relationship. But a less formal look at that period is instructive.

We know that in the two economic expansions before the current one, the unemployment rates averaged 5.6 percent and 5.3 percent and reached lows of 3.8 percent and 4.4 percent. And in neither case did low unemployment become an inflation problem. The 1991-2000 expansion started with a 5.1 percent (12 month) core CPI inflation rate; that declined to an average core inflation rate of 2.9 percent over the long expansion that followed. In the 2002-2007 expansion, the core inflation rate averaged 2.1 percent and peaked at 2.8 percent.

We also know that while rapid inflation is a problem that can be costly to undo, a little inflation is a good thing. The Fed is trying to achieve faster growth of wages as feature of a healthier labor market, and that means welcoming a slightly higher rate of price inflation.

So the Fed will not hit the brakes too soon. It may well choose to raise the Funds rate a bit before long. But that will not indicate a serious tightening of policy is under way. Moreover, we should not expect to see a particular rate of unemployment become the target of policy. From where we are now, it is not possible to say what that rate should be. The Fed will tighten if and when too rapid inflation becomes a clear risk, and that may still be years away.