The Federal Reserve chose to keep its target for the fed funds rate at 5.25 percent at its latest meeting, and the language in its statement stayed much the same, too: While the Fed expects inflation to moderate, it noted once again that a “high level of resource utilization has the potential to sustain those [inflationary] pressures.”
The Fed’s characterization of inflation as something driven by high-resource utilization is without a doubt striking for some. Rational economists define inflation as a monetary phenomenon that rears its ugly head when there is too much money creation relative to demand. Resource utilization is never mentioned, and with good reason.
To measure inflation in capacity or labor terms is to assume both are static in nature. In truth, when producers run out of capacity to utilize, they receive a signal to expand their productive capacity. Similarly, when unemployment is low, wages adjust upward, and in the process provide sidelined workers with a market signal that their services are in demand. To the extent that help-wanted ads go unanswered, businesses have proven adept at adjusting there too. The proliferation of ATM machines is but one example of how markets readily adapt to low levels of worker availability.
Another flaw with measuring inflation in resource-utilization terms is related to the fact that U.S. businesses of all sizes are increasingly global in both their capacity and human utilization. Boeing is presently building its 787 Dreamliner in six countries around the world, and as Lou Dobbs constantly reminds us, U.S. firms regularly outsource jobs to parts of the world where labor is very much underutilized. So, even if inflation were a function of high resource utilization, it’s pretty clear that worldwide resources are nowhere near their limits.
Even if we assume that capacity and labor utilization are high within the U.S., this, if anything, would put a damper on inflationary pressures. When businesses produce goods for sale, and when workers supply labor, they are implicitly demanding money. So we can say the total amount of goods and labor for sale on any given day constitutes demand for money. Hence, when the economy is growing, dollar liquidity is shrinking. Or, when the economy is losing steam, liquidity is expanding. If resource utilization is subsiding alongside rising unemployment, the signal is that the demand for money has shrunk, or that there’s too much liquidity. That’s why inflation correlates so well with economic weakness.
Without addressing how the dollar’s weakness in recent years has stimulated real inflation, high resource and labor utilization is by definition an inflation fighter since more goods and labor are being offered, and as such, the demand for dollars is greater. So, contrary to the Fed consensus, a growing economy is the perfect cure for inflation, since a growing economy will serve to soak up excess dollar liquidity.
When the Fed targets non-monetary indicators to manage what is a monetary phenomenon, it retards the market signals that businesses and workers rely on to choose when and how to deploy their mechanical and human capital. Worse, such Fed machinations may succeed in cooling the economy without lowering inflation.
– John Tamny is editor of RealClearMarkets. He can be reached at [email protected].