Wednesday, June 8, 2011

The Fed's (inadvertent) role in the class war

To give some context to Bernanke's remarks yesterday about inflation being "transitory" and his apparent blindness to commodity inflation, investors should consider the recent paper by Gauti Eggertsson of the New York Fed which asked, "Commodity Prices and the Mistake of 1937: Would Modern Economists Make the Same Mistake?"

Eggertsson discussed the episode in 1937 when the Fed saw a burst of commodity inflation and responded with a tightening policy. He rhetorically asked:
The question for the contemporary reader is this: If we could transport a modern-day economist back to 1937, would he or she have made the same mistake? My suggested answer—admittedly somewhat hopeful—is no. I base this view on the fact that most economists today distinguish between the temporary movements in the consumer price index that stem from volatility in commodity prices and the movements that reflect fundamental inflation pressures. Hence a modern economist most likely would have identified the price rise in 1936 and 1937 as a temporary upswing in commodity prices that did not signal a significant increase in overall inflation.
In other words, modern economists would view the current episode of commodity and asset inflation as transitory and the Fed should not react with a tighter monetary policy.

Different kinds of inflation = Different winners and losers
While there are the usual caveats to the Eggertsson discussion that it does not represent the views of the New York Fed, it is clear to me that the sanguine attitude towards commodity and asset inflation is dominant at the Bernanke Fed.

This got me to thinking about central bankers think about inflation, which is mainly measured as core CPI, or some inflation measure ex-food and energy, i.e. commodity prices. The central bankers of the developed world today learned in the 1970's the way to break the back of inflationary expectations is watch labor costs carefully. If you don't allow labor costs to rise, then you suppress the feedback loop that leads to ever rising inflationary expectations. (Meanwhile outside of the West, things are different. Consider this iMFDirect comment about how food inflation has affected the Middle East).

Indeed, we can see that philosophy at work at the Fed. The accompanying chart shows that US hourly earnings (red line) have lagged the increase in CPI (blue line) for the past few decades.

While that approach may be a solution to controlling inflation, such a technique creates different winners and losers. When the Fed turns a blind eye to asset inflation and but remains vigilant on wage inflation, it tilts the playing field in favor of the owners of capital and away from the suppliers of labor.

Add that to that the current ugly employment situation...

...a record low in labor's share of national income (as per David Rosenberg)...

...and the fiscal ingredient of ever present calls for lower individual and corporate income tax rates (but not payroll tax rates), you have the ingredients of a class war. Taken to its logical end, America loses its competitiveness and becomes Argentina.


redonkulus476 said...

I think this blogger is hugely wrong. 1) Why should the Fed tighten monetary policy just because some volatile commodities have risen in price? Should they loosen monetary policy when those prices swing back down again? That's a recipe for volatile, unpredictable monetary policy.

2) Low, stable inflation (maybe 2-3%) is good for both capital and labor. Overly tight monetary policy is bad for both (see USA in 1929-1933 or Japan since 1995 or so.) Why does he think that higher asset prices won't also help the working class? What do the rich do with their new found wealth? Don't the working/middle classes have any stocks in their pension funds? Do any of them work for publicly traded companies? Do any of them own houses or gold?

Edward said...

It's extremely unlikely that past financial disaters will ever repeat itself as it is well documented what those policy shortfalls were; furthermore, North American policy makers and central bankers have the benefit of Japan guiding us (i.e. policies in a low interest rate environment).

It will be sometime before the Fed will actually raise Fed Funds - for whatever the current reasons are. For now, moral suasion and reduction in Quantitive Easing is action du jour.

Sion said...

This is so blindingly obvious I'm amazed anyone would disagree.