The curve is flat

The flat yield curve has announced that markets are not concerned about inflation in the near to medium future. This is a reasonable expectation, since the only countries feeding inflationary finance on any scale, Japan and China, have motivation and opportunity to tighten up. So it is reasonable to ask why Ben Bernanke is raising interest rates.

Is it concern about asset prices? Six months ago people seemed convinced that a bubble in the US housing market was about to burst. Some cogent analysis since then shows that a few professional center cities (mainly on the coasts) account for most of the increase (I read about it in Paul Krugman’s column). This is more reminiscent of the home price increases in Southern Britain in the 90s, which did not lead to any collapse or to any inflation problem.

Rapid adjustment to capital flows through home price surges is characteristic of regional imbalances, and one reason why complete price stability is a bad idea. (If prices must change by zero on average, the stickiness of prices in the declining regions will force the central bank to restrain the economy an extra amount overall, in order to hold down the prices in advancing regions. In a declining home market, sellers stiffly resist selling for lower prices, and a large share of the adjustment takes place as waiting, as failure to transact. The net result is falling employment in the declining areas, and restraint of employment in the surging areas by government overreaction. The tendency to reduce employment easily turns into lost output and, before long, foregone capacity.)

(And of course wages work the same way, so most businesses facing declining real demand need the outlet that is granted by failing to give raises in the face of mild inflation. I have heard this dismissed as history of thought, but some monetarists seem determined to resurrect it as real economics by making the same mistakes that have been made in the past).

Is inflation a growing threat? If you think the strain on resource supplies from China’s and India’s development is a source of continual inflationary pressures, maybe. But at the same time these countries are reducing the cost of manufactured goods and services. Looking in another direction, a decline in foreign financial inflows could at any moment cause a drop in the dollar, which would in fact raise inflation (on a one-time basis, like nearly all supply shocks). And at the same time such a shift would tend to increase interest rates, meaning that the monetary tightening in advance of such a source of inflation would have been redundant. More fundamentally, all of these represent supply shocks, from the standpoint of the U.S., and therefore I have argued and would still argue that they call for lower interest rates, or at least not higher ones.

The US government, including the Fed, should be more concerned with how wage adjustment to foreign competition can take place. Clearly the competition from abroad is undermining U.S. wages, on average and especially at the low end. The Earned Income Tax Credit cushioned the drag to some extent in the 90s, and of course there was a boom on. But concerns over immigration are a good indication that pressures are now building up again. What kinds of pressures? Unemployment among the young. Pension plans, and even companies, that are going broke because their retirees are earning at levels that seemed reasonable when contracts were negotiated 20 or 30 years ago. Inability of manufacturing firms to afford medical costs.

A good old Keynesian answer is to allow nominal wages to stay the same by creating some inflation. Then real wages can decline, but the real relative bargaining strength is unchanged, so workers are not in a position to ask for nominal increases.

One reason for raising interest rates might be to keep capital flowing in, to avoid the inflation and possible simultaneous recession that will come when Asians (and Arabs) decide to quit putting good money after bad, as it were. Considering all of the pain that day will bring, it certainly seems understandable. But long experience shows it is better to face an obvious reckoning sooner rather than later. The overhang of investments that will lose value when it comes is getting to be catastrophic, leading to uncomfortable questions of who will get their money out first. Letting the dollar fall sooner would instead add to manufacturing competitiveness, and let U.S. wages fall in real terms internationally, again without the period of unemployment that a nominal fall would require.

It seems to me these are the more pressing questions, and the ones lurking in people’s minds waiting to be sorted out. But Bernanke is backing a 50 basis point increase in the Federal Funds rate.

Let’s be generous and assume it is one of those required macho displays that new central bankers always oblige with. A fair prediction is that the US economy will slow by 2 percentage points as a result. So growth next year will be only 1 percent, instead of this year’s likely 3. Too late for the elections, but considering that this quarter saw only 1.6 % annual growth, even this year may be dropping. Sales of new homes in February were down a whopping 10%. If it weren’t so painful, it would be amusing to contemplate how the Fed will be backpaddling furiously, say around October, after another engineered slowdown like the one in 2000. And then we will be treated to another 18 months of pushing on a string. The good news is that if Bush responds to this one by proposing tax cuts for the rich, like he did last time, the Republicans will be out on their ears in 2008.