Don’t forget factor shares, the Fed’s balance sheet, and a bunch of other reasons to discount inflationary fears

November 7th, 2016 at 9:44 am

I’ve written very little about the Fed in recent weeks, in part because there’s this other thing going on, but more because I don’t have much to say that isn’t being amply said elsewhere. But it’s not even 9am yet and I’ve already bumped into a number of Fed-related arguments that seem worth weighing in on.

I ran into an economist friend this morning who–and the dude is not alone–argued that the Fed is already behind the curve on inflation. Say what?

–First, where’s the inflation, either actual or expected? Last year, core PCE inflation, year-over-year, rose either 1.3, 1.4, or 1.5 percent in every month. This year, it has gone up either 1.6 or 1.7 percent every month. So yes, if you want to argue that price growth in the Fed’s preferred gauge has accelerated, I agree. But that’s of course what you’d expect as the economy improved and more resources were utilized. Even with a relatively flat Phillip’s curve, we expect some firming of prices. Increasing inflation is not out-of-control, un-anchored, or spiraling inflation.

–Magnitudes matter! Those number I just cited are still persistent misses from the Fed’s 2 percent target, and just as importantly, such a gradual, low-variance trend confirms that inflation expectations remain well-anchored, as you can see here. And please, 2 percent’s an average, not a ceiling, right? Right? Anyone? Bueller…?

–There’s got to be more than free-flowing anxiety behind this claim of spiraling price growth waiting to pounce. I’ve seen no such evidence.

–Some point to wage acceleration. Different wage series show different trends, but if you mash them together, as is my wont, you find that the tightening job market has, in fact, given workers a bit more bargaining clout and nominal wage growth basically moved up from 2 to 2.5 percent. That’s good news! And again, it’s exactly what you’d predict as we close in on full employment.

–Moreover, there’s no evidence that faster wage growth has been inflationary. See point one above, as well as this next point:

–Double moreover, here’s an important source of non-inflationary wage growth: a rebalancing of the “factor shares” of national income. See the figure below on labor share (the compensation share of national income) from a recent CEA post. You’ll note the recent tick up in labor share, but it still remains well below recent peaks. As workers’ bargaining clout improves, that shift should continue. In fact, we’re already hearing some whining about wages squeezing profits–I’d argue there’s lots of losses to make up in that space, but the point here is that wage gains from that source are not a source of price pressure.

Source: CEA

Source: CEA

–Finally, Brad DeLong asks a fair question: “Why, if you want to tighten monetary policy, are you doing so first by raising interest rates rather than by shrinking the balance sheet?” The Fed’s balance sheet hasn’t grown of late (figure below) but it’s still highly elevated and surely a weapon against an unforeseen inflation shock. I can’t speak to the relative impact magnitudes of raising rates vs. unwinding the balance sheet, but my prior is that operationally, the latter would be constitute less of a brake-tap than the former.

Source: Federal Reserve

Source: Federal Reserve

I’m not going to plotz if the Fed raises 25 basis points in December. Part of this is hawk management by Chair Yellen. But I still consider the Fed to be pretty much the one rational, data-driven institution we have left. Yet some of this inflationary phantom menace stuff makes me worry that some folks over there could catch the Beltway fever–you know, the one where your vision Trumps the facts.

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One comment in reply to "Don’t forget factor shares, the Fed’s balance sheet, and a bunch of other reasons to discount inflationary fears"

  1. Smith says:

    You’ve lost before you started as soon as you concede 2% is even an acceptable average target, let alone a ceiling. Again, non-recession years with unemployment at or below 5%, and year’s inflation average 2% or below? 4 years since 1955 (they are 1998, 1965, 1956, and 1955).
    Next, the entire concept of controlling inflation with with interest rates needs to be scrapped. This is because it was never very useful, or efficient, but now causes more harm than good. It masks the central problem of controlling prices, and ignores the previous effective ways prices were actually controlled. Competition, regulation, 90% taxes on incomes above $1 million, strong labor, wage floors and more equitable distribution of income. Skewed incomes mean businesses can make $100 profit selling one item, vs $10 selling 10 items. It creates an incentive for raising prices. Same profit, but less employment needed, and higher prices beyond costs, the very definition of inflation.
    Control prices by controlling prices, change the conversation to ask how and why businesses are allowed to cause inflation by raising prices? What stupid mechanism allows them to raise prices without causing sales to fall? End the deregulation of banks and interest rates (since 1978 and 1980) One also needs a thorough economic history revision that says Paul Volcker is not the hero of the modern economy and the 1980s is a very disturbing model to emulate.

    Here is the DeLong link on Fed moves:
    Here is actual pros, cons, and speculation of reasons for assets selloff vs. rate hikes: