Archive | March 2014

An update on Abenomics

Via FTAlphaville, I found a graph from this paper:


Abenomics is having a huge effect on output compared, which is somewhat masked by demographic decline in the working population.

So when will the ECB realise that QE is an effective policy tool which increases output during a depression, and get on with saving the EZ?

Update to Wage Growth Does Not Necessitate Inflation

Marcus Nunes left a link to a Cleveland Fed Paper which has some interesting remarks about wage inflation and price inflation:

…since labor costs are a large fraction of a firm’s total costs of production, rising wages and compensation should put pressure on firms to pass these higher costs on as higher prices. We have several reasons to doubt the accuracy of this view. First, if a wage increase is brought about by increased labor productivity, it will not create inflationary pressure.3 Second, a wage increase will not create inflationary pressure if it leads to a squeeze in profits because a firm cannot pass along cost increases. No firm inherits the right to simply “mark-up” the prices of its output as a constant proportion above its costs; competitive market pressures strongly influence the pricing decisions of firms. Finally, causation could work in the opposite direction: An increase in aggregate demand may permit firms to raise the price of their products, and the resulting increase in profits would lead workers to demand higher wages in future negotiations.

And just in case you missed their meaning…

It turns out that the vast majority of the published evidence suggests that there is little reason to believe that wage inflation causes price inflation. In fact, it is more often found that price inflation causes wage inflation. Our recent research, which updates and expands on the current literature, also provides little support for the view that wage gains cause inflation. Moreover, wage inflation does a very poor job of predicting price inflation throughout the 1990s, while money growth and productivity growth sometimes do a better job. The policy conclusion to be drawn is that wage inflation, whether measured using labor compensation, wages, or unit-labor-costs growth, is not a reliable predictor of inflationary pressures.

So if the hawks could all stop clamouring that a tighter labour market means the start of a wage-price spiral of death, that would be great, and dare I say it, rational.

Wage Growth Does Not Necessitate Inflation

There seems to be a certain segment of the economic commentariat who believe that whatever the reason, tightening is the answer. The latest reason to tighten is that there is evidence that the labour market is tightening. Wage growth in the US is staging a modest recovery.

However, this does not imply that the CPI is going to rise. Lets have a quick look at average hourly compensation vs inflation since 2000.

Compensation and Inflation

We can see that inflation and wage growth typically track each other fairly closely. This correlation is likely spurious, an artefact of the fact that productivity growth and population growth have similar magnitudes. I am more interested in the effect of total compensation on inflation. Since the argument goes that wage growth leads to inflation, lets note first that wage growth is still far below historical norms.

Inflation is generated when demand outstrips supply. Labour market tightening means that workers have better bargaining positions, and then can bargain for better wages. Wage growth is coming, and wage growth means rising AD, but inflation comes only when AD outstrips AS. There are two reasons that that this might not happen at once:

(1) Productivity growth. It is a feature of recessions generally that Capex falls because companies do not invest in productivity enhancements in an environment of weak demand. Technological progress marches on regardless, and the result is that there is a steady stream of available but unbuilt productivity enhancements that a company could invest in. Thus we should expect that productivity growth could stage a catch up. This is supported by the general observation that RGDP has grown on the same trendline for decades, and it would be a remarkable coincidence if trend growth had a secular change exactly at a time that happened to have a financial crises.

(2) Corporate Profit Margins. CPI measures consumer prices, which is not quite the same thing as monetary inflation. This is punishing on the way down, when consumer prices do not fall in line with the changing money demand, but can be beneficial on the way up. For example, a decline in corporate profit margins as a tighter labour market allows workers to capture more of their marginal product can give you rising demand without rising consumer prices.

The economy is complicated, and no one can predict what will happen with perfect certainty, but you should not give undue credence to those who tell you that rising wage growth is certain to generate inflationary pressure. As in the late nineties, wage growth can be large while inflation is low for years at a time. We have two plausible stories that can support the hypothesis that this is a likely outcome, it is certainly where I would place my chips.