Wages are not driving inflation (much)

Good morning. On Wednesday I looked at discount retailers’ results and wrote that it is “increasingly clear that lower-income consumers are under pressure and are changing their spending habits meaningfully.” Yesterday Dollar General, another discounter, reported results that confirmed this ugly trend emphatically. “We continue to see signs of increasing financial strain on our customers as they seek affordable options, including increased reliance on [store] brands and items at or below the $1 price point,” the CEO told analysts. The shares fell by a fifth. Economic slowdowns do not unfold smoothly; they are the sum of an irregular series of unpleasant surprises. Email me: [email protected]

The case for not freaking out about the jobs report 

This morning’s jobs report has been even more keenly anticipated than usual. The reason is that investors’ confidence that interest rates have peaked and will soon fall has been replaced by nagging uncertainties. There is a nasty suspicion that rates will stay higher for longer — as those Cassandras down at the Federal Reserve have long warned — or, worse, might rise another notch or two.

A recent speech by Fed Governor Philip Jefferson signalled to the market that a rate increase is unlikely at this month’s Fed meeting, but further down the road the range of possibilities is wide. Recent equivocal economic data — a hot job openings report, a cool manufacturing ISM survey — have only focused more attention on the jobs numbers.

If the jobs report comes in much stronger than the consensus estimate of 195,000 new jobs, there might be a bit of a market freak out. But there is reason to remain calm: a tight labour market might not be as important a contributor to inflation as is generally believed.

The labour market receives so much attention in part because Fed chair Jay Powell told everyone to watch it closely. In a press conference last November, he split core inflation into three categories: goods, housing services, and non-housing services (NHS). The first two are likely to fall with time, he said, but

core services other than housing . . . may be the most important category for understanding the future evolution of core inflation. Because wages make up the largest cost in delivering these services, the labour market holds the key to understanding inflation in this category

“The key to understanding inflation”! Yowza! Since then, as Omair Sharif of Inflation Insights pointed out to me yesterday, Powell has tried to walk back this comment somewhat. Nonetheless, it is common to see the Fed’s inflation challenge described as, in essence, the challenge of cooling the labour market.

But two economic luminaries — Ben Bernanke and Olivier Blanchard — have just released a paper in which they argue that the labour market has not been a major contributor to recent inflation. The paper is framed around the argument, earlier in the pandemic era, between inflation optimists and pessimists. The optimists, including the Fed leadership, thought heavy fiscal stimulus would not spark inflation because the Phillips curve has flattened (that is, inflation has become less sensitive to the level of employment), and because inflation expectations had been so low for so long. The pessimists, Blanchard among them, contended that

[The] increase in aggregate demand likely to result from the unprecedentedly large fiscal transfers, together with the cumulative effects of the easing of monetary policy begun in March 2020, could cause more overheating of an already-tight labour market than the optimists expected. An extremely low unemployment rate might in turn cause the Phillips curve to steepen. Moreover, higher and, consequently, more psychologically salient levels of inflation might lead inflation expectations to de-anchor, raising the potential for a wage-price spiral

While the pessimists were right about inflation rising sharply, they were wrong about the role of the labour market, according to Bernanke and Blanchard. Using a “bare-bones” economic model, they find that “both the Fed and its critics underestimated the inflationary potential of developments in goods markets”, and that “that labour market tightness made at most a modest contribution to inflation early on”.

My colleague Martin Sandbu argued yesterday that the Bernanke/Blanchard analysis supports the “team transitory” view of inflation. On that view, inflation was caused by a series of bad supply shocks that are working there way through various sectors of the economy. If this is so, the right policy response is to step back and let this process work itself out, rather than continuing to tighten policy (Bernanke and Blanchard themselves are more hawkish).

The Bernanke/Blanchard model may be “bare bones”, but it is not easy for a non-economist like myself to follow the specifics. Happily, Adam Shapiro of the San Francisco Fed published a paper arguing for the same conclusion with a simpler argument.

First, Shapiro tracks the impact of surprise increases in wages (as measured by the employment cost index) on core inflation (as measured by the personal consumption expenditures index), while controlling for other variables. In particular, he looks at NHS inflation, where wages are the largest component of costs. What he finds is that

The impact of the ECI on NHS inflation is statistically significant, but the magnitude is quite small. A 1pp increase in the ECI increases the contribution of NHS inflation to core PCE inflation by 0.15 percentage points over four years — an effect of 0.04pp per year. As ECI growth has increased by about 3pp from its pre-pandemic level, this means that labour costs have added approximately 0.1pp to current core PCE inflation.

That’s not much! Next, Shapiro looks at the different effects of wage increases on supply- and demand-driven inflation. He distinguishes the two kinds of inflation by looking at the movements of prices and unit volumes. With supply-driven inflation, prices move up but volumes fall (there is less stuff to sell, so the price of each unit goes up); with demand-driven inflation, the two move together (suppliers raise prices and sell more stuff to eager customers). He finds surprise increases in ECI wages have no impact on demand-driven inflation, suggesting that “businesses tend to raise prices when wages rise because their costs increase, not because demand increases”.

Sharif, of Inflation Insights, makes broadly the same point without any economic model at all: he just takes a close look at the NHS inflation data.

He notes that about two-thirds of big surge in NHS inflation in 2021-2022 versus the pre-pandemic baseline was driven by transportation services, a category that includes airfares, auto insurance, and auto repair. How much of the increase in transportation services inflation was driven, in turn, by wage increases? Not much, Sharif thinks.

He points to the example of the airlines industry. Looking at the total increase in quarterly industry operating costs between the second quarters of 2021 and 2022 (as reported by the Bureau of Transportation Statistics), increased labour costs accounted for less than a fifth of the change. Fuel was the main culprit, followed by things such as maintenance, food for passengers, advertising, and insurance (the “transport related” and “other” expenses in the table below):

All of this suggests we should not obsess too much about labour market tightness — or at any rate, obsess about it less than we have in the last year or two. Of course, accepting this, we still have to think carefully about what else is driving inflation and what is likely to happen next. But that is another discussion. For now, just don’t freak out about today’s jobs report.

One good read

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