Different varieties of inflation
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.