The Phantom Menace
By PAUL KRUGMAN
Published: June 16, 2006

Over the last few weeks monetary officials have sounded increasingly worried about rising prices. On Wednesday, Richard Fisher, the president of the Federal Reserve Bank of Dallas, declared that inflation “is running at a rate that is just too corrosive to be accepted by a virtuous central banker.”

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.

The point is that wage increases can be a major driver of inflation only if workers consistently receive raises that substantially exceed productivity growth. And that just hasn’t been happening.

In fact, the distinctive feature of the current economic expansion — the reason most Americans are unhappy with the state of the economy, in spite of good numbers for the gross domestic product and explosive growth in corporate profits — is the disconnect between rising worker productivity and stagnant wages. Over the past five years productivity, as measured by real G.D.P. per hour worked, has risen by about 14 percent, but the real wages of nonmanagerial workers have risen less than 2 percent.

Nor is there much sign that things are changing on that front. The official unemployment rate is low by historical standards, but workers still don’t seem to have much bargaining power. (Does this mean that the official unemployment rate makes the job situation look better than it really is? Yes.) The Federal Reserve’s Beige Book, an informal survey of economic conditions across the country, reports that over the last couple of months “wage pressures remained moderate over all, with the exception being workers with hotly demanded skills.”

But if wage pressures are so moderate, where’s the inflation coming from? The answer is soaring oil and commodity prices.

It’s true that some widely used inflation measures, like so-called core inflation, strip out the direct “first-round” effects of rising energy prices. But there are still indirect effects, which usually take some time to show up in the data. Much of the recent rise in core inflation probably represents the delayed effect of the big run-up in fuel prices a few months ago. And unless something else happens to drive up oil prices — like, to give a wild example, a military strike on Iran — inflation will probably subside in the months ahead.

And bear in mind that many economists, including Ben Bernanke, the Federal Reserve chairman, have said that a little bit of inflation — say, 2 percent a year on average — is actually good for the economy.

It would be an exaggeration to say that there’s no inflation threat at all. I can think of ways in which inflation could become a problem. But it’s much easier to think of ways in which the Federal Reserve, wrongly focused on the phantom menace of a new wage-price spiral, could be slow to respond to bigger threats, like a rapidly deflating housing bubble.

So I don’t fear inflation nearly as much as I fear the fear of inflation. And I wish the Fed would lighten up on the subject.