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.

Economist Hulk, and other musings

I have never really been into Twitter, but Economist Hulk is really pretty awesome. The perfect mix of humour and economics. In fact I like him so much that I am now signed up on Twitter under @phil_20686. We will see how it goes.

Today Hulk SMASHED Tory headquarters. Shortly after Hulk SMASHED Ed Balls’ comments in his interview last week. Here is a selection of quotes where Hulk sets out his view of the UK economy:

1/10 HULK GRAPH UK CPI AT CONSTANT TAXES VS US PCE. HULK SEE BOE SUCCESSFULLY MAINTAINING 2% INFLATION, UNLIKE FED http://imgur.com/4JyPTvE 

2/10 HULK SAY IF CENTRAL BANK IS TARGETING 2% INFLATION, THEN FISCAL POLICY HAS NO PREDICTABLE IMPACT ON DEMAND

5/10 HULK NOT SURPRISED AT UNEMPLOYMENT WHEN YOU TARGET 2% INFLATION IN FACE OF REAL COST PRESSURES

6/10 HULK THEREFORE THINK MORE DEMAND GOOD FOR THE UK, BUT THAT THIS NOT FEASIBLE WHILE MAINTAINING 2% INFLATION IN SHORT/MEDIUM TERM

So we have talked in several previous posts about the equivalence of fiscal and monetary policy, and that wishing for more fiscal stimulus and the BoE to hit its inflation target is self defeating. I wanted to talk mostly about point (5). Milton Friedman once said that “Inflation is everywhere and always a monetary phenomenon.” In an important sense this is true, as by controlling the money supply, a central bank can, in the long run, hit any inflationary or deflationary target that it wishes to. However, there is an important sense in which it is not true: not all changes in the price of goods are due to changes in the value of money.

For quite a long time now, developed economies generally, and the UK, as a small island economy, in particular, have been exporting the more labour intensive parts of industry to regions of the world where labour is cheaper, while we concentrate on higher value manufacturing. Despite a political discourse centred on the `hollowing out’ of UK manufacturing, we remain the sixth largest manufacturer in the world by output value. However, we can think of the economy in the following way: we have inputs, then we have labour, and then we have outputs. We call increases in the price level of outputs `inflation’, and wage increases `nominal wage growth’. However, if the price of inputs rises, then the price of output can rise even in the absence of wage growth. For the UK, whose economy is largely centred on domestic consumption,  this is a problem, as wage growth is needed to ensure there is sufficient demand.

There is pretty good evidence that this has been happening in the US since 2000 or so, cannibalising a graph of inputs to manufacturing from an earlier post (courtesy of BLS),

Note the steadily rising `materials share’. We should really consider this `the wages of Brazilian Miners’. Increasing productivity has been captured by the workforce of developing nations, who do most of the basic material manufacturing that we use as inputs to developed world manufacturing.

Inflation targeting is identical to targeting nominal wage growth provided that the price of inputs remains broadly stable, or at least changes slowly compared to the rate of inflation and the rate of productivity increases. Since the financial crisis, this has no longer been true. Indeed, it may not have been true before that. The lesson should be that in the case of increasing cost of inputs, nominal wage growth can decouple from `price inflation’. That is the position that the UK finds itself in right now, with high inflation and essentially zero wage growth.

Fortunately for us, this `Factor Price Equalisation’ has happened once before, when, following the end of the Bretton Woods agreement, Japan, South Korea, and Taiwan were integrated into the global economy, they got rapidly improving living standards and increasing cost of labour, and we got cheap imports. Evan Soltas provided an excellent analysis of those events here. The BRIC’s are the same story again. Labour costs will remain depressed roughly until their work force becomes fully urbanised, at that point the bargaining power of labour improves, and unit labour prices rise, dramatically increasing the cost of inputs to developed world manufacturing and putting pressure on the price level of the outputs.

In such a world, targeting inflation in the price level deliberately suppresses nominal income growth and causes unemployment, or at least very slow recoveries. In one sense, a fall in relative living standards (at least compared to the counterfactual of benefiting from cheap labour forever) is the price of falling world inequality, in the long run, when catchup growth has run its course and the whole world is `developed’, larger markets will lead to more technological innovation.

I brought up the global context, because I think it makes it easier to see why the UK monetary policy is failing. At the end of the day, input prices are beyond the control of the central bank. Output prices are within the control of a central bank only in so far as it can constrain the growth of nominal wages. As wages are sticky, a central bank can control inflation if and only if changes in inputs are small compared with the desired inflation target. The good news is that because these `inflationary factors’ are real, they are largely independent of monetary policy. Thus, if we opt for monetary expansion, we will get rising employment, and rising demand, but probably not a lot of extra inflation. I point this out because many pundits are drawing exactly the opposite conclusion, that the fact that inflation is high and demand is weak points to the failure of monetary policy.

Doubtless, there are some among you who doubt that the UK inflation is not caused by the BoE’s `loose policy’. I point you to my earlier post on this topic. I also point you to the excellent Britmouse post on the seven offical measures of Uk inflation. Note that since money is a common element of all price indexes, if changes in the value of money dominated real factors, all these measures would be identical. Instead of varying by about 15% cumulatively since 2009.

This post has meandered a little bit. It was meant to be short and snappy, but that didn’t really happen. 🙂 So, to summarise,

PHIL LOVE ECONOMIST HULK. TOGETHER WE SMASH UK MONETARY POLICY.

Sticky Wages

This is a very quick observation to reblog a graph from a Krugman Column. Namely:

Further evidence of deflation.

This odd looking spike is further evidence that the US would be in deflation were it not for nominal wage rigidities. See my previous post for a more indepth comment.