Friday, April 27, 2018

Wage pressure is not inflationary.

The employment cost index for the first quarter continues to show some moderate strength.  This has led to new discussion about inflation, etc.

I have written a few posts about the Phillips Curve - the idea that wage growth and inflation are related, or that rising wages lead to rising inflation.  I don't think this relationship works the way it is generally described.  Monetary inflation should certainly cause wages to rise just as it should cause all price levels to rise.  Clearly there is causation going in that direction.  I think the apparent causation going in the other direction is misleading.  It is a matter of only feeling parts of the elephant.

One main piece of evidence that makes it look like rising wages lead to inflation is that firms report tight profit margins that are being squeezed by rising wages.  They either have to raise prices or reduce profits.  It seems likely that this would produce price pressure.  The idea of cost-push inflation is alluring, but not useful.

First, there are two potential sources of wage pressure.

1) Rising capacity utilization.

2) Fundamental productivity growth.

On point 1, as unemployed workers return to the labor force and the pool of potential workers declines, there are pressures on wages.  But, an economy running below capacity is not a productive economy.  In this context, both wages and profits should rise, but this should be more than compensated for by the boost in productivity caused by utilizing productive capacity.  Wage and profit growth should be real, in this context.  If anything, this sort of growth should be disinflationary as real growth would be strong.

On point 2, it is difficult to grasp in real time the full complement of mechanisms that are in play.  And, we will be more likely to see ailing, dying industries that we are familiar with than new, disruptive industries that are the source of new productivity.  Here, also, it will appear that rising wages are inflationary, but they are not.

Here, it might be useful to think of Amazon vs. brick and mortar book stores.  Wage growth was strong in the late 1990s, and it would have been tempting to look at rising wages at brick and mortar book stores, and to forecast inflation.  That is because those were mature businesses, so they had a very stable and understandable cost structure.  Wages were rising, and they either had to raise prices or lose profits.

But, what we were seeing there wasn't price pressure.  What we were seeing was productive transformation in an economy.  What we were seeing was the end of a business model that wasn't profitable any more.  When any business model comes to the end of its life because of new innovation and productivity, it will look like it is suffering from cost pressures.   But, to the extent that those cost pressures were acute, they simply led to the transformation to new, more productive business models.

Amazon, on the other hand, was hiring like mad.  And, nobody was looking at Amazon as a source of inflationary wages.  That's funny, really.  Because, since Amazon was young, they were not particularly profitable themselves.  But, nobody looks at a young, disruptive company and says, "Oh, labor costs are cutting into their profits, this could lead to inflation."  That's because Amazon wasn't trying to become profitable by cutting costs.  They were trying to become profitable by hiring and growing.

There was a lot of that going on in the late 1990s.  So, profits were low, wages were growing, and inflation was moderating.  And, the stock market didn't seem too put out by the whole state of affairs.

By the way, interest rates were also high at the time, but they weren't high because the Federal Reserve was trying to discipline risk-takers by sucking cash out of the economy.  They were high because investors were risk-takers, and so the safety of fixed income was not highly valued at the time.  The appetite for risk wasn't expressed through borrowing.  It was expressed through Amazon's rising stock price.  It was expressed through expanding equity, not debt.

Rising wages are a sign of progress.  They are something to be encouraged, not tempered.  When wage growth is strong, real interest rates might naturally rise, but there is no reason to try to force them to in order to stop the business cycle.


  1. Why would you conclude that the Fed is raising rates to "stop the business cycle?" Inflation is basically at-target and the Fed's own future inflation gauge shows it rising to considerably over-target by year end. Raising rates seems in-line with the goals of monetary policy.

  2. Good point. The comment wasn't necessarily addressed solely to the FOMC, but to the general commentariate and finance folks who are afraid of bubbles and inflation.

    1. Well i do think inflation is a legitimate worry, but more so in a political sense than an economic sense. Let's say there is a longer lag between CB easing and inflation than we believe. In the interim that easing creates "wealth," that "wealth" gains power/influence. If the time were to come when a wealth-destructing CB tightening were necessary to contain inflation it may not be politically possible due to the aforementioned influence. A central bank could easily paint itself into a corner. This is a risk that central banks should be aware of.

    2. Why do you think CB easing creates wealth? Unexpected inflation is a transfer from creditors to debtors.

      Even in the Austrian type of misallocation story, lagging inflation would have to mean that years after loose CB policy, debtor firms have unexpected nominal gains, which would then trigger investment, which eventually provides poor returns. So, there would be malinvestment in, like 2020 or 2021, which would go bad when the CB finally had to tighten in 2023 or something?

      Is there a mechanism you are expecting that I'm missing?

    3. Isn't the mechanism simply the "wealth effect" transmission mechanism. Strikes me that financial assets respond first to CB easing...and only after some unknown period of time do we find out how much of that is actually "wealth."

      This is a silly example but I think it holds: if we print $1t and give it to Bill Gates and he buries it in his backyard it shows up as "wealth". And he gains the influence commensurate with an extra $1t in wealth. If he then decides to buy oil with it 10 years from now, the "wealth" quickly becomes "inflation" (partially). The world was essentially fooled.

      We have no idea what the true level of interest rates is nor the true earnings power of corporates until policy is "normalized." In the interim, both can appear to be valued much more highly than they should be.

  3. Excellent blogging.

    By the way, if we worship wish for voters and the employee population to embrace free enterprise, it would behoove us to make sure real wages grow nicely over time.

    1. True. That's the perpetual challenge. Bad policy begets bad policy.

  4. I miss the late 90's. I remember TIPS yielding 3.4% plus inflation.


    housing investment still very soft

  6. "Wage pressure is not inflationary"--KE.


    Even more:

    Q1 unit labor costs up 1.1% YOY.

    The media played the Q1 BLS press release as a "surge in wages." This is our "left-wing" media? Egads.

    The Q1 standalone showed some wage boost, compared to Q4. But lone quarterly figures are often revised, or revesered in the following quarter.

    In fact unit labor costs are up about 1% )total!) from Q2 of 2016.


    1. Interesting.

      I keep seeing references to corporate reports of rising wages or squeezed margins, as if that is a sign, in and of itself, of inflation. But, it seems to me that in an economy approaching full utilization, there will naturally be a shift among sectors in both price and quantity. Sectors will rise or fall in either respect, but at the end of the day, the net effect of all of that is a product of Fed policy. Rising wages of, say, restaurant wait staff, can be a predictable result of a mature recovery without saying anything about aggregate inflation.

  8. Here's a grim chuckle. If the Fed plays it right, it can cause not just a US, but perhaps global recession…again….

    "Asia fears another 'taper tantrum' as US rates climb
    Nikkei Asian Review-5 hours ago
    BANGKOK -- Rising U.S. interest rates threaten to spark upheaval in Southeast Asian financial markets if investors pull out of the fast-growing region, cutting off fuel to a critical engine of global economic development. On April 24, yields on 10-year U.S. Treasurys hit 3% for the first time since the beginning of 2014. If the U.S. …"


  9. "squeezed margins"

    actually corporate profits are at zeniths, record zeniths, both absolutely and a safe of GDP. Way higher than the Reagan days…..

    this is good news…but depressing to see all the ranting about wages….