Inflation can be measured in a number of different ways. There is no “correct” measure of inflation, rather the utility of various inflation indices depends on the question being asked. Consider the following FT story:
On both sides of the Atlantic, hawks insist “core” inflation (excluding food and energy) remains too high. But consumers face the overall not the core price level. The claim must be that falling headline inflation will not bring core inflation down, even though rising headline inflation is what pulled core inflation up.
It is misleading to say that rising headline inflation is what pulled the core rate up, rather it was primarily excessive NGDP growth that pushed core inflation higher. But I’m more interested in the other claim, that consumers face the overall inflation rate, not core inflation.
It’s true that consumers are hurt more by high headline inflation than by high core inflation. But that truth obscures another important fact. Monetary policymakers can help consumers more by stabilizing core inflation than by stabilizing headline inflation.
Did I just contradict myself? Read the two claims carefully, and consider an example such as the case where headline inflation is much higher than core inflation due to soaring oil prices. In that case, consumers will probably be worse off, as wages tend to track the (lower) core inflation rate. But there’s nothing the Fed can do to prevent consumers from suffering from a fall in living standards due to a rise in the relative price of oil. A high relative price of oil is a problem for consumers, but it is not a problem that can be fixed by monetary policymakers. The overall macroeconomy will be more stable (and consumers will be better off), if the Fed stabilizes core inflation rather than headline inflation.
The same is true of wage inflation. Obviously, the public prefers higher wages to lower wages, other things equal. But when it comes to the effect of monetary policy on wages, other things are not equal. A monetary policy that drives nominal wages higher will also lead to higher price inflation. The FT article seems to miss this point:
Wage “inflation” due to people getting more productive jobs in more productive companies is surely not harmful inflation. Higher productivity should itself be disinflationary for prices. Yet this possibility seems far from the minds and certainly from the words of central bankers. . . .
But from the gold standard era to today, they [central banks] have also been accused of something worse: of always taking capital’s side in a distributive battle against the working class. They should be wary of proving their critics right.
Again, higher wages are better for workers, ceteris paribus. But higher nominal wages generated by expansionary monetary policy will generally make the public worse off, at least in the long run. Workers care about real wages.
Productivity growth has been very slow since 2004, and there is no reason to assume that this trend will change in the near future. Thus a monetary policy that leads to fast nominal wage growth will also generate high inflation. When the central bank then tries to slow inflation with a contractionary monetary policy, there’s a danger the economy will fall into recession. It is better to avoid the excessive stimulus in the first place, rather than try to clean up the mess without triggering a recession.
In order to achieve 2% inflation in the long run, wage growth must be held down to roughly 3%, on average. The extra 1% represents productivity growth.
READER COMMENTS
vince
Dec 27 2022 at 1:29pm
“Again, higher wages are better for workers, ceteris paribus. ”
Of course, it’s impossible to have higher wages and ceteris paribus. Without a productivity increase, higher wages are paid from higher prices. I assume that’s what you mean by making the public worse off in the long run.
Warren Platts
Dec 28 2022 at 6:23am
Not necessarily. Since Production = Wages + Profits, higher wages can be paid for with lower profits. And vice versa, of course; that is what has actually happened over the last 40-50 years: labor’s share of the national income has declined mainly because of import competition.
Indeed, the decline in wages can probably explain at least some of decline in productivity growth: high wages incentivise the development of labor-saving devices; conversely, when wages are low, it’s easier to just add more labor in order to increase production.
vince
Dec 28 2022 at 2:49pm
I look at profit as another form of wages. It’s the compensation to the entrepreneur.
Wage Dove
Dec 29 2022 at 5:24pm
I think this is what a lot of economists including the Fed are currently getting wrong and has a high likelihood of causing a policy error next year sending us into a recession (or having a worse recession than the counterfactual).
Pretty much all leading measures of inflation are pointing strongly downward and coincident measures just went past the inflection point as well the past couple months.
Except for wages. And that’s what the FOMC keeps focusing on talking about JOLTS and what not. Ignoring the increase in the corporate profit margin post-COVID which should revert back.
It seems to me Professor Sumner may be committing the same error he acknowledges standard central banks commit by focusing on inflation rather than NGDP growth, by focusing on wage growth rather than NGDP growth.
If the high wage growth happens due to profit margin reversion, then over the short term high wage growth can occur without a corresponding overshoot of NGDP growth, I think (and of course could be wrong) that this is where we are in the cycle.
Overtightening could end up being disastrous not just for the economy as a whole but for labor’s share as well.
Spencer
Dec 28 2022 at 11:06am
Economics is about the rate-of-change in the flow-of-funds. It is about the circular flow of income – and income not spent.
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Unless the upper income quintiles savings (highest shares of income), are expeditiously put back to work, completing the circuit income and transaction’s velocity of funds, a dampening economic impact results.
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It’s shades of Jeckel Island. The ABA is the most dominate economic oligarch.
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Banks don’t lend deposits. Deposits are the result of lending. Savings are not synonymous with the money supply. And the NBFIs are the DFI’s customers.
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The elimination of Reg. Q Ceilings on commercial banks was a conspiracy.
Spencer
Dec 28 2022 at 11:20am
Paul Volcker Pg. 224 ; “Keeping At It”: “How did central bankers fall into the trap of assigning such weight to tiny changes in a single statistic, with all of its inherent weakness?”
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Monetary policy objectives should not be in terms of any particular rate or range of growth of any price index. Rather, policy should be formulated in terms of desired RoC’s in monetary flows, volume times transaction’s velocity, where N-gDp is both a proxy and a subset of American Yale Professor Irving Fisher’s truistic “equation of exchange” M*Vt = P*T.
Warren Platts
Dec 28 2022 at 12:09pm
Uh, that depends on which public we are talking about. Sure, workers like higher wages, but owners like lower wages. The problem for owners is that wages are “sticky.” Asking workers to take nominal pay cuts is a good way to get them to quit. The answer, of course, is inflation.
For example, under the Trump administration, working class wage growth outstripped upper class salary growth for the first time in living memory. Thus if a subsequent administration wanted to reverse those gains, a bout of inflation would be just the ticket!
I gotta give Greg Mankiw the credit for being honest enough to state this point explicitly in his textbook. In the section entitled “One Benefit of Inflation,” instead of the usual idea that inflation discourages hoarding of cash, we get the following:
Thus certain publics (owners) will be made better off by inflation because it provides a stealthy way of increasing their share of the national income.
Cui bono!
vince
Dec 28 2022 at 3:15pm
Not conspicuously, but the Fed admits that an inflation target helps employers reduce real wages.
https://www.clevelandfed.org/center-for-inflation-research/inflation-101/why-does-the-fed-care-technical
Scott Sumner
Dec 28 2022 at 5:29pm
So monetary inflation reduces real wages in the short run, and has no impact in the long run—making my point even stronger.
Warren Platts
Dec 29 2022 at 3:38pm
Agree that inflation is not the root cause (but only the means) of the undeniable, long-term decline in Labor’s share of the National Income that began about 1970. (Since then Labor’s share has declined from about 65% to less than 60% as of 2019; albeit there was a nice ramp-up during the dot-com boom — that promptly crashed again after China PNTR.) The root cause, I guess, is the fact that the correlation between wages & productivity is not as strong as it used to be (cf. Krugman’s “Ricardo’s Difficult Idea.”)
https://fred.stlouisfed.org/graph/fredgraph.png?g=Yeqt
Scott Sumner
Dec 30 2022 at 11:05am
Keep in mind that the rise in the share going to “capital” is not going to business, it’s going to the implicit rent on owner occupied homes. Wages plus implicit rent on the home you own is stable as a share of national income. So the wage/productivity relationship still holds.
Jeff
Dec 30 2022 at 1:41am
I don’t understand how you can be confident in the “no impact in the long run” claim. Isn’t it possible that people tricked by money illusion into thinking their real wage increases are higher than they actually are will pass up opportunities to develop themselves and thereby increase their wages more substantially? Isn’t it possible that in some circumstances inflation could act as palliative that causes low productivity growth?
Scott Sumner
Dec 30 2022 at 11:06am
Not precisely zero, but approximately zero. (Could be slightly more or less.)
Richard W Fulmer
Dec 29 2022 at 1:10pm
Consumer-price inflation gets most of the attention while asset inflation is largely ignored. Yet, it seems to me that asset inflation matters a lot. During the 1920s, the Fed increased the money supply by almost 50%. Thanks to a tremendous increase in productivity consumer prices remained largely flat, but housing and stock prices soared.
Similarly, despite the Fed’s loose money policies following the 2007-2008 housing bust, consumer prices remained stable – at least until mid-2021. However, the price of the average home more than doubled and the Dow Jones Industrial Average nearly tripled. Rising stock prices led companies to “invest” in things like stock buybacks rather than in R&D and capital improvement and expansion. One of the results was stagnating productivity and, with it, stagnating wages.
Asset inflation also drives up the net worth of individuals who own their own homes and who are invested in the stock market, leading to an increasing wealth gap that fuels resentment. Of course, much of that “paper wealth” will disappear when the bubble bursts, but the resentment won’t disappear as nearly as quickly as will the gap.
Finally, the Fed’s remedy (raising interest rates) for consumer-price inflation will, if it works, tame inflation, not by soaking up the money that was pumped into the economy during the pandemic, but by reducing velocity – that is by reducing investment. At least part of the inflation we’re experiencing is the result of the drop in production caused by the lockdowns and by consumers hunkering down at home. Slowing production further, then, seems to me to be counterproductive.
vince
Dec 31 2022 at 12:58pm
The Fed has claimed it’s too hard to recognize asset price bubbles. Yet they seem to be quite confident in their ability to recognize and interfere with asset price corrections.
sketical monetarist
Dec 31 2022 at 1:14pm
I am not sure whether it is acceptable to ask for homework help here; though I’ll give it a try. I am taking a financial markets course and an assignment asked us to describe whether the current monetary stance of central banks is expansionary or restrictive. When I drew the line through the M1 and M2 in a time series from 2010-2019, the line was almost exactly linear. It was only with COVID in 2020 that there was a leap in money supply. First lesson for me was that Friedman was correct: inflation is a monetary phenomena.I find it highly disingenuous that central banks talk endlessly about excess demand, supply side shocks etc. etc. and never seem to get around to how their extreme money supply expansion during COVID was the underlying causal feature of our current inflation spiral.
Next, observation was that the liquidity preference model of Keynes also worked perfectly. In 2020 interest rates plunged (liquidity effect) and then in 2022 when the price level and expected inflation effects kicked interest rates soared.
One thing I am uncertain about is why central banks interpret economic growth as the problem. Currently, central banks are fixated on stalling economic growth. This seems completely bizarre to me. Wouldn’t more economic growth, more goods actually be deflationary? The idea is that economic growth could help provide money with “real” value and remove the inflationary excess from hollow money increases. Basically, if monetarists can dream of a helicopter drop of money, then why can’t the people dream of a helicopter drop of real goods produced in the real economy? Sort of like an economic Santa Claus?
vince
Jan 1 2023 at 2:05pm
1. The current stance is meant to be restrictive. Whether it’s restrictive enough to contain inflation isn’t clear yet.
2. The jump in money supply actually started in September 2019 after repo market rates shot up.
3. More economic growth would be great, but unemployment is already low. It’s also easier to adjust the money supply than to create economic growth. More importantly, the Federal Reserve is in charge of the money supply, not policies that promote economic growth. That’s up to Congress. They’d rather blame the Fed, who isn’t elected, than take a policy action that might be good but unpopular.
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