Sunday, September 27, 2009

Dismissing Slack to Raise Inflation Fears

The Wall Street Journal on Monday (yes, I am that far behind) had a lengthy article on the slack in the economy. And while the article goes in depth on various components of the economy that have room to make up before inflation could ever begin to kick in, they of course get it (purposefully) wrong.

The begin the discussion on track:
The interplay between slack and inflation is at the heart of that decision [for the Fed to raise interest rates]. Slack is important to their equation because, in theory, it should suppress wages and keep inflation down.

You can sense the skepticism there, but it continues:
But if the Fed misreads the dimensions or significance of slack, it could unleash an unwelcome bout of rising prices.

Not wrong, but you're beginning to see their thesis. And then:
The risk of inflation is significant.

Alright, back down. There is a difference between long-term and short-term here. Sure, keeping rates low after the recovery begins kicking in (like the Fed did under a different Administration) could certainly lead to inflation. I'll agree that the timing is critical, but the risk right now is not significant.

Of course, it's not just a question of rates. The liquidity in the system, will need to be absorbed as well. And budget deficits don't help. But durable goods order shrunk last month, the ISM manufacturing index barely crossed 50 into positive territory, and jobs will continue to be a problem for some time. I don't think we're in much danger right now of rising prices.

The article then injects an interesting theory:
If businesses and workers expect more inflation, the theory goes, they start demanding wage and price increases and set off the inflation they fear.

So, I'm a manufacturer, let's say, who believes that the Fed is really mucking things up and inflation is right around the corner. And, though, I haven't seen an increase in raw material prices yet, I'm going to raise prices in a struggling economy to try and recapture some of the money I think I'm going to lose in the future.

Or, I'm a union rep negotiating a new contract, when job losses are happening all around me, and I'm going to demand wage increases for men and women who are grateful to have jobs because I think that the cost of living is going to rise, at some point.

Both things would be a mistake. And, yes, I could see how those things could help stir up inflation, but the likelihood of anyone taking those risks when recovery is still uncertain is pretty low.

Though the article throws in plenty of numbers and some good quotes on the extent of slack in the economy, the purpose of the article is clearly to gin up inflation fears. Maybe it's just a supply-side issue, and the people overly concerned about inflation are just ignoring the demand side of things that becomes increasingly critical when things turn bad. Waiting too long to raise interest rates is dangerous, but raising interest rates will not lead us to recovery.

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