Thursday, June 15, 2006

Phantom Menace

As we've all learned, when wages go up the headlines imply it's worrying-to-bad news. Fortunately, then, we haven't had all that much of such bad news lately. As Krugman points out that's why the obsessive fear of inflation is misplaced (behind wall):

I'm worried too — but not about recent price increases. What worries me, instead, is the Fed's overreaction to those increases. When it comes to inflation, the main thing we have to fear is fear itself.

Discussions of inflation can be numbingly arcane — are you a core C.P.I. type or a trimmed-mean P.C.E. person? But the real issue is whether there's a serious risk that inflation will become embedded in the economy.

The classic example of embedded inflation is the wage-price spiral — better described as wage-price leapfrogging — of the 1970's. Back then, whenever wage contracts came up for renewal, workers demanded big raises, both to catch up with past inflation and to offset expected future inflation. And whenever companies changed their prices, they raised them by a lot, both to catch up with past wage increases and to offset expected future increases.

The result of this leapfrogging process was that inflation became a self-sustaining process, feeding on itself. And ending that self-sustaining process proved very difficult. The Fed eventually brought the inflation of the 1970's under control, but only by raising interest rates so high that in the early 1980's the U.S. economy suffered its worst slump since the Great Depression.

Fed officials now seem worried that we may be seeing the start of another round of self-sustaining inflation. But is that a realistic fear? Only if you think we can have a wage-price spiral without, you know, the wages part.