Worries about inflation have been pervasive ever since the Fed began trying to lift the economy out of recession. If the Fed does not tighten policy very soon we have been told repeatedly, an outbreak of inflation is inevitable. But so far, those worries have been unfounded.
The latest round of worries is tied to the belief that labor markets are tighter than it appears from standard statistics such as the unemployment rate. If the Fed does not begin reversing its stimulative policies right away we are warned, a wage-price inflation spiral will occur. Martin Feldstein, for example, has made the case for this view. He argues that even though the unemployment rate remains relatively high, it is largely because of the long-term unemployment problem.
Short-term unemployment, which is where most of the action is for labor market turnover, is much lower – low enough to make it difficult to fill many types of positions and cause upward pressure on wages. There are other arguments as well, for example, that potential output has fallen during the crisis, and we are closer to full employment than we think. If policy is not reversed soon, the economy will overheat and be inflationary.
If these claims are correct, we ought to see evidence for them in the form of wage increases in a broad swath of job categories. But the evidence is just not there. As Jared Bernstein’s analysis shows, “there’s just no wage pressure to speak of. Growth rates of disparate series are all bumping at or near historical lows.” Of course, it could be that although we haven’t seen wage growth yet, it is just around the corner.
For inflation hawks, disaster is always just around the corner, and the predicted doom has failed to materialize again and again. Instead of responding to potentially false claims, we should wait until we actually see consistent, broad based wage growth before we conclude that labor markets are tight enough to begin worrying about an overheated economy.
There is an argument that the Fed should begin to tighten policy prior to wages actually rising, as would be the case if wages were a “lagging indicator” of inflation. But this argument is offset by an asymmetry in the costs of inflation and unemployment. The cost of tightening too soon is a higher unemployment rate. Higher unemployment is very costly in both human and economic terms, and the effects are not easily reversed.
However, inflation is not nearly as harmful – most of the costs are eliminated through the indexing of wages, interest rates, and prices to the rate of inflation – and it is much more easily reversed. If we are going to make a mistake, then it ought to be in the direction of higher inflation rather than higher unemployment. Given all the false cries about inflation that we have heard throughout the recession, policymakers should wait until the evidence for inflation is clear before removing stimulus measures. And the evidence for wage growth is not clear at all.
Though it is taking much longer than we would like, labor markets will tighten eventually and when they do wages will begin to increase. Will this cause a wage-price spiral and an inflation problem?
Not unless the Fed plays along. The classic story for how this works comes from the 1970s, a time when workers had much more bargaining power than they have today, and a time when the Fed that didn’t understand the nature of the wage-price spiral problem. In this story, unions would demand higher wages, and this would slow the economy and increase unemployment.
The Fed would respond by expanding the money supply sufficiently to reverse the employment losses, and the expansion in the money supply would drive prices higher. As prices increased, the gains that unions had obtained for workers were reversed, and unions responded by demanding even higher wages to regain what had been lost. At this point, we are back to the beginning of the story and the process repeats itself.
As this happens, the result is an ever-expanding money supply and a continuous increase in prices, i.e. inflation. But this is unlikely to happen today. First, unions do not have anywhere near the power they had several decades ago when this story was fashionable, so their ability to continuously demand higher wages is suspect. Second, the Fed has learned from the past and is unlikely to repeat its mistakes.
The bottom line is that there is little reason to worry about an inflationary wage-price spiral. For one, there is no evidence of wage growth in the data. But more importantly, if and when the Fed does see clear evidence of inflation, it won’t respond as it did in the past.
The Fed has learned its lesson and signs of an inflation problem will be met by interest rate increases sufficient to end the threat. Thus, the big fear at present is not that the Fed will enable a wage price spiral that results in high and persistent inflation; it’s that the Fed will respond too quickly to any sign of inflation and increase interest rates too soon.
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