Is Inflation A Problem?

By:  Dr. Charles Lieberman

Date:  8/4/2008

Some Fed officials are concerned that inflation is becoming a problem and are willing to raise interest rates to contain it. While it is good that inflation isn't being ignored while attention is focused on the sluggish economy, there's little reason to think inflation deserves so much concern, as yet. We expect interest rates to remain unchanged for many months, providing the time needed for the economy to regain its health.

Economist and policymakers typically focus on "core" inflation, i.e. total inflation excluding food and energy. Critics make the point that this policy is directed for the benefit of everyone, except those unfortunate souls who must eat and heat or cool their homes or must drive. Indeed, total inflation, measured by the CPI, has increased 5.0% over the past 12 months, versus just 2.4% for the "core" measure. Still, theres little substance behind the critics. Raising interest rates will not supply a single barrel of crude oil, or bushel of wheat or corn. There is little the Fed can do to contain inflation pressures that originate as a result of commodity shortages.

In fact, commodities are such a statistically small component of consumer prices that it really takes very large price surges to have much impact of measured inflation, as has occurred over the past 12 months. Normally, labor costs are actually vastly more important, accounting for roughly 70% of the total cost of producing GDP. It is inconceivable and mathematically impossible for labor costs to rise significantly without also driving up consumer prices. Thus, the Fed normally focuses on labor costs as a key indicator of whether underlying inflation pressures are increasing.

The Fed is also extremely concerned with inflation expectations, since if food and energy costs rise sufficiently, consumers may expect inflation to worsen. In response, workers may press for larger wage increases, thereby creating the worsening inflation pressures they fear. This is precisely the Fed's concern today. While wages costs remain well behaved, food and energy prices have surged and workers are somewhat more fearful that prices will rise more generally. Should that occur, there's no doubt the Fed would raise interest rates to address inflation. But as long as the economy remains weak and wage rates do not increase meaningfully, the Fed can afford to leave interest rates at low levels to stimulate growth. Thus, we expect monetary policy to remain unchanged for some time, since labor costs and core inflation are well behaved, while economic growth remains soft. The Fed will not raise rates until growth looks significantly healthier, likely not until 2009.

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