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When will the Fed Act? Not Before Inflation is 'Broad-Based'

Author: Roger M. Kubarych
April 22, 2004
Council on Foreign Relations

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Fed Chairman Alan Greenspan has frequently used Congressional testimony as the means to let the markets know his policy views. So in the days leading up to his appearances this week before the Senate Banking Committee on Tuesday and the Joint Economic Committee (JEC) on Wednesday, turnover in the fixed-income markets in the US and in other major financial centers tapered off considerably. Two months ago, Greenspan told a different Congressional Committee that the economy was “off to a strong start in 2004” with good prospects. He noted that “with short-term real interest rates close to zero, monetary policy remains highly accommodative” and that “fiscal policy appears likely to stay expansionary”. But his key judgment was that “increases in efficiency and a significant level of underutilized resources should help keep a lid on inflation”.

Since then, the US economy has behaved as he assumed it would. But evidence has mounted that the lid is not firmly restraining inflation any more. Would he retract that statement and thereby signal that the Fed’s patience was wearing thin? Or would he dismiss the inflation data and assert that the evidence wasn’t strong enough to justify an early move by the Fed to raise interest rates?

We now know that he did both. In the question-and-answer session following his testimony Tuesday to the Banking Committee, he stressed that “pricing power” of American companies was gradually being restored. That was in sharp contrast to last year, when many corporations complained that they had no ability to raise prices. That in turn had made the Chairman worried about a deflation threat. He said Tuesday that “threats of deflation” are “no longer an issue” for the Fed.

Rightly or wrongly, this was taken by the financial markets as a clear signal that the Fed is close to raising the Federal funds rate. Both the stock market and the bond market sold off sharply, while the dollar resumed its recent rally against the euro, the yen, and other major currencies.

However, the “trailer” – which is the word Hollywood movie studios use to describe the previews of coming attractions meant to whet our appetite for their next films – was not an entirely accurate representation of the full written statement that the Fed Chairman would present to the Joint Economic Committee Wednesday morning. The hawkish tone was absent. The written testimony never mentions the phrase “pricing power”. It never mentions the word “deflation”, either.

To the contrary, the tone of the written statement was dovish, barely changed from February’s testimony, despite the unmistakable signs of rising inflation. Here is what the Chairman said on Wednesday: “… although the recent data suggest that the worrisome trend of disinflation presumably has come to an end, still-significant productivity growth and a sizable margin of underutilized resources, to date, have checked any sustained acceleration of the general price level and should continue to do so for a time.“

So the good news is that disinflation “presumably” has come to an end – the Fed appears not to be sure of even that yet. But notwithstanding the rise of 5.1% per annum in the CPI during the first quarter (or 2.9% in the core rate), “any sustained acceleration of the general price level” has been checked. The dovish tone continued throughout the question-and-answer period.

What are the implications for policy? As in several recent speeches and testimonies, Greenspan is definitely warning financial market participants that the next move in monetary policy is toward higher interest rates. He repeated this clearly: “… the federal funds rate must rise at some point to prevent pressures on price inflation from eventually emerging.” But when? Not right now. Why not? Because “as yet, the protracted period of monetary accommodation has not fostered an environment in which broad-based inflation pressures appear to be building.”

Later, in the question-and-answer period, Greenspan reiterated his long-standing belief that the main price indexes, even the personal consumption deflator he has designated as the Fed’s main benchmark for inflation, are biased upward because they do not take account sufficiently of quality improvements. So any rise in the price indexes is less worrisome than otherwise.

When will the emerging inflationary uptrend now evident be sufficient to be considered “broad-based?” No straightforward answer is given. But the inference from both the text and the question-and-answers is that it will depend on labor cost developments. Greenspan emphasized that profits have been rising during the recent pick-up in economic activity and gains in worker compensation have been slender. As a result, the share of pre-tax profits in the national income has jumped by a remarkable 5 percentage points, from a “very low” 7% in the third quarter of 2001 to a “high” 12% in the fourth quarter of 2003. As profits have risen, the incentives for businesses to expand have also gone up. His hunch is that they will start to hire more vigorously at some point. That will tighten the labor market enough to begin pushing up wages.

Next week, we will get some important insights into recent trends in labor compensation when the quarterly employment cost index for the first quarter of 2004 is published. That is the best measure because it incorporates both wages and benefits. Lately, wages have been rising only modestly, but benefits costs have been climbing rapidly, especially the costs of employer-funded health care insurance. As a result, the employment cost index went up 0.7% in the fourth quarter of last year, after a big 1% rise in the preceding quarter. Should there be another above-trend increase in the employment cost index, Fed optimism about inflationary prospects will need to be reassessed.

Is the Fed on the verge of an early tightening of monetary policy? Based on the Chairman’s testimony on Tuesday, the answer would be yes. But based on his written text and subsequent comments on Wednesday, the answer would be no. The conclusion is that policy will be dictated primarily by the evolution of the inflation numbers and especially what happens to labor costs. When they start to accelerate, the Fed will remind the markets that “the Federal Reserve recognizes that sustained prosperity requires the maintenance of price stability and will act, as necessary, to ensure that outcome.” The Fed will raise official short-term interest rates—but not yet.

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