Preemptive Fed moves harder as
inflation models fail
By Marjorie Olster
SAN FRANCISCO, Sept 29 (Reuters) - If you drive at night
without headlights, it's certainly harder to avoid accidents.
Likewise, the Federal Reserve seems to be having a tougher time
plotting preemptive strikes on inflation these days because the
rising productivity of American workers and other factors mean many of the models it uses to
forecast growth and price pressures are proving less reliable, pointing to potential car wrecks that so
far have not come to pass.
Current and former Fed officials and prominent U.S. economists expressed that view at a National
Association for Business Economics (NABE) conference in San Francisco this week.
Former Fed vice chairman Alan Blinder said the Phillips curve, one of the theoretical foundations of
Fed inflation models in recent years, has been disappointing lately as a predictor of inflation. The
Phillips curve, named after British economist A.W. Phillips, holds that wages rise faster when
demand for labor is strong.
But U.S. unemployment has been lingering around 4-1/4 percent, nearly a three-decade low, for
many months while the core Consumer Price Index (CPI) has actually been edging lower. Wage
inflation has remained subdued, leaving many economists at a loss for an explanation.
``The truth was the Phillips curve was working very well in explaining what was happening in the
U.S. economy (a few years ago) but its performance has deteriorated sharply. When you lose
confidence in your Phillips curve model, as (the Fed) must have given the facts, it's natural and
sensible to be less preemptive, to move on a forecast,' Blinder said.
At the heart of this economic mystery -- or economic ``miracle' as some call it -- is the productivity
conundrum. American workers' efficiency has risen sharply in the last few years as the benefits from
heavy investment in computers and other new technology have become apparent in economic
statistics.
That productivity gain, along with a number of other special factors like a strong dollar, low
commodity and oil prices, falling computer prices, falling health care costs and a downturn in the
global economy, are the most-often-cited explanations for the surprising coexistence of low inflation
and fast growth.
All of this means that the Fed has come around to the idea that the economy can expand faster than
once thought without generating inflation. But they don't really know how fast. Right now, their best
guess is somewhere around 3.0-3.25 percent gross domestic product growth annually.
U.S. economic growth has been about 4.0 percent annually since 1996, and a poll taken at the
NABE conference sees 1999 growth at 3.8 percent.
Still, many economists are uncertain about the durability and sustainability of the productivity gains
and whether they are broadly based or concentrated in just a few sectors such as the production of
computers and computer chips.
Those doubts have made many at the Fed reluctant to cast out the old models entirely and some are
choosing instead to just fine-tune trusted theories.
One of the Fed's enduring mantras is that early, or preemptive, strikes on inflation threats are more
effective than reactive monetary policy at maintaining price stability.
But San Francisco Fed President Robert Parry told NABE conference participants on Monday the
Fed should probably wait to see an actual rise in inflation, not just a threat, before it hikes interest
rates again because of the uncertainty about its inflation forecasting models.
``Suppose, like now, we're uncertain about the underlying model of the economy. In that case,
preemptive policy can lead to the wrong action,' Parry said.
``When there's a high degree of uncertainty about forecasts, it could be best for policy to be more
cautious -- in the extreme, to wait until inflation actually starts to rise before acting to tighten. With
high uncertainty about the future, a somewhat delayed action could be preferable to running the risk
of tightening when it's not warranted.'
The arguments presented at the conference by Blinder and Parry weighed heavily against a rate hike
at the Fed's next policy-setting meeting on Oct. 5 given that there are few signs of rising inflation
despite persistently strong U.S. consumer spending, fast growth and low unemployment.
The Federal Open Market Committee (FOMC) already raised rates in June and August even though
the main measures of U.S. consumer price and wage inflation were very well under control. The Fed
argued that strong domestic demand, tight labor markets and economic recovery overseas posed an
inflation threat down the road.
Parry said the sustainability of an increase in U.S. productivity growth over the past several years is
the single biggest uncertainty in the current economic outlook and for monetary policy.
``For policy, this uncertainty complicates the question of whether FOMC actions should be strongly
preemptive or more cautious.'
Blinder, an academic heavyweight who teaches at Princeton University, said he and other
economists are ``basically clueless' when it comes to explaining how U.S. unemployment has stayed
so low over the past year without generating inflation.
Another theory once widely touted by the Fed, the NAIRU, has lost its luster as well. The NAIRU,
which stands for non- accelerating inflation rate of unemployment, held that inflation would begin to
rise when the national unemployment rate fell below 6.0 percent.
This of course did not happen leaving economists to puzzle over why.
``That is a very surprising set of events and it raises the question for the first time in a serious way of
whether the NAIRU may actually be down in the neighbourhood of where we are now,' Blinder
said.
Parry said he now believes the NAIRU is a number that begins with five.
As for the productivity question, Parry said he does see evidence that productivity gains are
stretching over a number of important sectors in the economy and he does see this as a longer term
shift in the economy.
``I do buy into the idea that we have seen a trend increase in productivity. I think there is reason to
debate and discuss the magnitude of that change and also its durability,' he said.
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