This morning's report that unemployment hit a 5-month high and job creation fell short of economists' estimates increases the odds that Fed Chair Ben Bernanke will stop raising interest rates after its next meeting. But today's Wall Street Journal [subscription required] revealed the key to Bernanke's thinking: He discounts the importance of rising consumer prices as he sets interest rate policy -- focusing instead on labor cost inflation.
This distinction is critically important to guessing Bernanke's next move because consumer price inflation is running at a 4.3% annual rate -- way above the 1.5% to 2% target that Bernanke's discussed in the past. However, labor costs have remained under tight control -- below 1%. Simply put, consumers are being squeezed with rising costs and flat wages, but the Fed does not care about this when it sets interest rates.
Bernanke's primary concern is whether the US economy can achieve its potential growth without straining its current labor force and business capacity. That is, the Fed cares about whether businesses can keep increasing production without paying its workers more.
My analysis of the numbers over the last 26 years suggests that there is a nice correlation between changes in capacity utilization -- the extent to which a factory is using its productive resources -- and changes in inflation. Here's an example of capacity utilization: A shoe factory can produce a maximum of say, 100 pairs of shoes an hour. If that factory's actual production is 80 shoes per hour, its capacity utilization is 80%.
The reason that there's a relationship between inflation and capacity utilization is fairly clear. If customer demand for a product is growing faster than a factory can produce that good, then at some point the factory will not be able to produce more units and will be in a position to increase prices. If the price increases hold and demand continues to rise for a while, then the company may eventually use the increased profits from the higher prices to build new capacity so it can meet the rising demand. Or it might just milk the opportunity to keep raising prices until demand growth slows.
My analysis of the last 26 years shows that in most of the years when capacity utilization increased, so did the rate of inflation. And in even more of the years when capacity utilization fell, the inflation rate also declined. Specifically, capacity utilization increased in 13 of the 26 years and in 8 of those 13 years, the inflation rate climbed. But when capacity utilization fell, there was a greater chance that the inflation rate would follow suit -- specifically capacity utilization fell in 13 of those years and in 10 of those 13 years, the inflation rate also went down.
This has a direct bearing on Bernanke's next move because since 2002, capacity utilization has climbed from 75.8% to 82.4% and the rate of consumer price inflation has increased from 1.1% to 4.3%. Meanwhile the rate at which wages are increasing has declined from 1% to 0.9%.
If Bernanke cared about consumer price increases, he would keep raising interest rates. However he cares about wage inflation. Thanks to bankruptcies in the airline and auto parts industries, layoffs in the auto industry, a rise in outsourcing, and competition from China and India, employers have been able to keep wage increases to a minimum.
Since Bernanke does not believe that wage inflation is likely, he is willing to let consumers -- with their debt encrusted balance sheets -- act as the shock absorber for the slowing economy so that businesses can keep piling up cash.
Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm, and a Professor of Management at Babson College.
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Reader Comments (Page 1 of 1)
8-04-2006 @ 11:54AM
Dan Brennan said...
Bernanke is old engough to remember cost-push inflation. As oil prices rise, no amount of interest rate crunching will affect the inflation coming from the higher fuel costs. The Fed should be reducing rates to offset the global pricing. Lower rates for credit cards, autos, and corporate borrowing would keep the enconomy growing.
8-04-2006 @ 12:20PM
G Dhillon said...
The erosion of middle class, and an aging population will add to an increase in social service. the government is becoming the employer of choice. we cannot continue this way without allowing economic expansion in new technolgies, which are now cash starved due to rising interest rates.It is the new technology companies that we need to depend on to sustain the middle class.
8-04-2006 @ 8:50PM
Mr. noitall said...
Well, it's a good thing Bernanke has all these conflicting stats. to work with ( wage inflation,price inflation, inflation excluding food and energy cost). So, whatever he decides to do, he'll have a stat. to back up his decision. I would make the prediction that the Fed pauses this coming Tuesday, and keeps rates at 5.25%. I base this decision on the fear stat. Bernanke is afraid to raise rates because he's afraid of the heat he'll take for..causing the stock market to tank, the real estate market to tank, and maybe triggering a recession. If he lowers rates (which is highly unlikely) he could get blamed for the continuing weakening of the dollar, and higher inflation. So by doing nothing for now, he avoids some criticism.