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.”

To be sure, the future course of inflation is open to debate. And to the Fed’s credit, it’s announced to the world that it reserves the right to resume rate hikes. But there’s a risk that letting time elapse will only give inflation more time to take root, forcing the central bank to be that much more severe with future increases in the price of money.
For those who are optimistic, there are potent disinflationary, and even deflationary forces to consider in the global economy, as evidenced in a range of markets. From prices paid for DVD players to the going rate for day laborers picking lettuce, there’s hard evidence showing that that path of least resistance for inflation is down.
So, why is core inflation rising? More importantly, what does the Fed intend to do about it?
Ours is an age of questions without comforting answers–a sharp contrast to the past 20 years. Navigating this new world order of monetary policy is an untested Fed head, charged with managing the world’s most important central bank at a time of potent cross currents and change in the global economy.
Risk, in other words, is alive and well. The challenge is figuring out how to price it. The bond market seems inclined to reassess the Fed’s decision to halt rate hikes. After the yield on the 10-year Treasury touched 4.88% on Tuesday–near the lowest level since April–traders have sold, raising the yield to around 4.93% as we write this morning.
The burden of proof is firmly on the Fed going forward. With that in mind, the history of inflation and central banks is clear: inflation usually wins in the long run, tempered by occasional but temporary wins on behalf central banks in the short run. Inflation, like unkempt rooms, weeds in the front lawn, and authoritarian governments, is part of the natural order. To the extent that central banks have engineered brief respites from inflation’s domination is a testament to innovative thinking and disciplined monetary management. But let’s be clear: eternal vigilance is necessary for battling inflation. That battle’s been relatively easy during the past generation, but it’s getting tougher in the 21st century.
Mr. Bernanke is betting that an economic slowdown will do the heavy lifting in the next stage of this battle. In effect, he’s betting that stagflation (rising inflation and declining economic growth) isn’t a threat. Let’s hope he’s right. But let’s also recognize that Mr. Bernanke’s wager has multiple outcomes.