The Federal Reserve’s decision on Tuesday to stop raising interest rates marks the start of a new phase for monetary policy. Only time will tell if this new phase is enlightened or something less. But no matter what comes next, ending the two-year campaign of rate hikes harbors a fair amount of risk at a time when inflationary momentum is picking up.
Bernanke is betting that an economic slowdown will cool inflation. The underlying assumption is that inflationary threats are self correcting. Unfortunately, history is less than clear when it comes to finding hard data to back up the assumption. In fact, recent history suggests the opposite. As we noted back on August 1, rate of increase in core inflation (as measured by personal consumption expenditures) has picked up recently just as the pace of personal consumption expenditures has turned lower. In other words, the primary engine of the economy (consumer spending) is softening at a time of rising inflation.
The Fed’s effectively arguing that it can now take a hands-off approach to managing inflation because economic growth will do the job. The issue is whether the Fed’s monetary policy in the recent past is partly or wholly responsible for the rise in core inflation in the here and now. If the central bank’s actions are accountable to a degree for the higher core inflation now, then it follows that the Fed must be proactive in bringing that inflation down (or preventing it from rising further).
Adding to the Fed’s burden is the fact that productivity in the American labor force slowed sharply in the second quarter while labor costs jumped, according to yesterday’s update from the Labor Department on productivity and costs. Labor costs increased at an annual rate of 4.2% during March through June, the fastest rate since 2004’s fourth quarter, and sharply higher than the 2.5% pace in this year’s first three months.
The rise in labor costs is “a warning shot across the Fed’s bow,” Joel Naroff, president of Naroff Economic Advisors in Holland, Pa., told U.S. News & World Report. “The Fed is facing a very difficult situation” between containing inflation and spurring growth, Naroff said. “It may not change the decision [to halt rising rates], but it puts pressure on them to make comments about how they are monitoring inflation.”