Fed target on inflation is painted on the backs of the middle class

Ben Bernanke told the Senator Chuck Schumer and the Joint Economic Committee on November 8, quote.

“... In all but the shortest of terms the Federal Reserve’s policy determines how much inflation there is, and we’re going to make sure that the inflationary impact that may come from the weakening dollar is not passed into broader prices and become part of the underlying inflation rate.”

The hubris is chilling.

What is inflation? It is a generalized rise in prices. A basket of consumer goods is priced from one period to the next and the rise in the sum of its prices is the rise in inflation.

Sometimes food and fuel are taken out of the basket purportedly to remove volatility, because their prices bounce around. The slightly emptier basket is called core inflation.

Bernanke is not encumbered by concern for the real world. A practicing economist who spoke to the point was Carl Weinberg, chief economist at High Frequency Economics (November 20, Bloomberg’s “On the Economy with Tom Keene).

“... The Fed is out to control the things it can control. When it comes to goods and services, things that are controlled by labor costs, the Fed is in there keeping an eye on it. It doesn’t mean headline inflation isn’t important, but it means that in terms of the Fed monitoring things in terms of what it can do, I think core inflation is probably the place to look.

“Something else to think about is when you see food prices go up, or you see energy prices go up, that’s not inflation. That’s a relative price change. And in fact, the analysis is very different when you see the price of food go up relative to the price of everything else, because it squeezes out consumption of other things and is actually a depressing impact on the economy as long as we don’t have wage increases to offset those food price increases. So generally speaking a rise in food prices brakes the economy by itself. A rise in energy prices brakes the economy as long as other prices are under control.”

We'll take up food and energy below, but the key point here is a primary component of prices -- up, down, or sideways -- is the wage rate, or remuneration to workers. Not, of course, as a separate item in the basket, but as an element of all the items, all the goods and services. This is particularly true of the core inflation basket. And this is the secret the Fed has found to keeping inflation down, keeping enough slack in the labor market.

Real wage rates have stagnated since the 1970s. “Real” means adjusted for inflation. Productivity has gone up by 50 percent. Wage rates could have adjusted upward by 50 percent. Imagine the economic dynamo. This is particularly true since the turn of the century (see chart). Productivity gains have not been realized by workers, but have been transferred to the upper classes (the rentiers, as Keynes called them) and to the producers of commodities and services, notably health care.

If we look at “core” inflation as a proxy for the price of labor, we begin to get a different take on inflation. The evil of rising labor prices is not so easy to fathom. If labor prices rise, demand rises, and presuming there is capacity in business, all boats rise. Labor prices can rise at the rate of productivity improvement without increasing inflation. Instead, labor prices have risen only at the lethargic rate of core inflation, thus real incomes have stagnated, as mentioned.

Combine this with the fact that food and fuel consume a great deal of the American budget, so removing them removes much of what is important to lower and middle class Americans. This "headline" inflation affects different economic levels differently. Food, fuel and health care make up a larger portion of the costs at the lower end. The rate of inflation has been greater for the bottom ranks of the population than for the top. In fact, the inflation rate goes up as you go down the income scale. This means the balance is made up at the upper end with lower inflation.

So when the Fed chairman insists he has the answer to the inflation problem, that the Fed controls inflation, the middle class of America should watch out. The interest rate button, the Fed’s tool of choice, is connected to a trap door under their jobs.