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Fed Preemptive Strike


The Fed launched a "pre-emptive strike" this week against an

unseen enemy — inflation — by raising interest rates one-quarter percentage

point. With inflation at its lowest level in 30 years (2.1%), why would the

Fed want to start down a path that could cost hundreds of thousands of workers

their jobs, slow the growth of wages, and raise the cost of borrowing to

millions of home owners and consumers?The Fed’s rationale is that labor

markets have gotten "too tight." For most Americans, the idea of

labor markets being "too tight" makes about as much sense as the air

getting "too clean" or people being "too happy." They have

a hard time understanding the hidden dangers of increasing job opportunities

and paychecks.

But the Fed has a theory in which this all makes sense. The Fed’s theory

says that if unemployment gets "too low," employees will begin to

demand higher wages and salaries. That could cause employers to raise prices,

leading to more wage demands. The Fed’s great fear is that an

"inflationary wage-price spiral" will spin out of control.

There has never been much evidence to support this theory. Some have argued

that the Fed is still fighting the last war — the inflation of the 1970s. But

even that inflation was the result of rising oil prices, not tight labor

markets. Previous bouts with inflation in the United States have generally

resulted from wars or other external events.

The holes in the Fed’s theory have been getting bigger and more numerous

each year, to the point where there is hardly anything left of it. Until four

years ago the Fed (along with most prominent economists) thought that 6 or

6.25 percent was as low as unemployment could fall without accelerating

inflation. That part of the theory has gone straight to the trash heap, as

unemployment has fallen to 4.2 percent while inflation has actually declined.

The structure of our economy has also changed since the Fed fought its last

battles against inflation twenty years ago. There is a good deal more

competition, especially from the international economy. While the majority of

employees have not benefited from this increased competition — their real

wages have been declining for more than two decades — it does make it more

difficult for companies to raise prices.

The Fed has recognized some of these changes but doesn’t seem to know how

to reconcile them with its dogma. According to the minutes of its February

meeting, a number of Fed policy makers "suggested that the inflation

process was not well understood and that inflation forecasts were subject to a

wide range of uncertainty." The New York Times aptly noted that this was

"like a conference of top cardiac surgeons deciding that it did not

really know how the heart works."

Last year the Fed lowered interest rates by three-quarters of a point, in

response to instability in the international financial system. And Fed

Chairman Alan Greenspan has also been afraid that raising interest rates might

tank a stock market that he knows is highly overvalued — he does not want to

get blamed for a crash. But he seemed to be preparing the public for this

possibility in his last speech: he noted that the bursting of a financial

bubble "need not be catastrophic," and that the stock market crash

of 1987 "left little lasting imprint on the American economy."

The Fed argues that we can’t wait until we can actually see inflation

rising before taking action to slow down the economy and wage growth. A host

of soothing metaphors in the business press, such as "tapping on the

brakes," or bring the economy in for "a soft landing" have

substituted for evidence and logic in shoring up the Fed’s argument.

But the real threat to our economy is not from rising wages but rising

interest rates. The conventional wisdom has it backwards: by the time the Fed

has done its damage, it will be too late (as in 1990) to avoid a painful

recession.

We need a pre-emptive strike, all right — not against inflation, but

against the Fed.

Mark Weisbrot is Research Director at the Preamble Center and a research

associate of the Economic Policy Institute, in Washington, D.C.

 

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