Inflation and real incomes

There's one widespread reason for optimism which I think is worth questioning. It's the idea that a fall in inflation next year will help to reverse the fall in real wages and so raise real households' incomes.

First, let's check the data. Since 1949 - when current records began - the correlation between annual inflation and annual growth in real personal disposable incomes has been minus 0.31. This seems to support the optimists' case; lower inflation is associated with higher real incomes.

However, much of this correlation is due to the mid-70s period, when a soaring oil price cut the real incomes of oil-consuming nations - a process exacerbated by the government's attempt to use wage control to fight inflation. Since 1980, the correlation has been a statistically insignificant minus 0.15.

There's a good reason why the correlation should be insignificant. It's that inflation has ambivalent effects upon real incomes.

If inflation falls because of a positive supply shock - such as a drop in commodity prices - then we would expect to see real wages and incomes rise.

However, if inflation falls because of weaker aggregate demand, then labour demand will be weak, which will hold down real incomes. Between the late 80s and the early 90s, for example, inflation fell but so too did income growth, precisely because of that weak demand.

Which brings me to our current predicament. There's no good reason to suppose that commodity prices will fall except because of random noise; remember Hotelling's rule? We cannot therefore bet on this source of a negative correlation between inflation and real income growth asserting itself. Granted, we could get the positive supply shock of a return to productivity growth, but this is more likely to benefit capitalists than workers in the first instance.

However, it's quite possible that inflation will fall because of weak aggregate demand and excess capacity. But these are conditions in which real wages won't rise much and might even continue to fall.

In saying all this, I'm not ruling out a recovery in real incomes next year; I know nothing about the future. It's just that if you want to contend that this will happen, you should simply contend that aggregate demand - and with it workers' bargaining power - will pick up briskly. Leave inflation out of it.

Comments

[Boffy]

Inflation is not a function of aggregate demand! Inflation is a monetary phenomena. There has been one reason that all the money printing over the last 30 years has not caused soaring consumer price inflation, and that is that the value of money declined only slightly more than the value of the commodities it was being exchanged against.

The evidence of that is to look at what happened to the prices of all those things that were not actually produced commodities, and whose values, therefore were not slashed. In other words look at what happened to asset prices. Whether you look, at shares, bonds, property or any similar asset class their prices have gone through the roof!

But, the basis of the fall in commodity values was a dramatic rise in productivity brought about by new technology, and the shift of large amounts of manufacturing production to China and other low wage economies. Now, both productivity growth is slowing, China is facing ever rising prices for inputs as a result of the growth of the last 15 years, and Chinese workers wages are rising sharply - in some case up to 50% p.a.

Imported Chinese manufactures still undercut domestically produced goods, but the prices of those goods is moving sharply higher. So, all the money printing that occurred over the last 30 years, and was sucked into blowing up those asset price bubbles, will now increasingly feed consumer price inflation.

That's another reason that interest rates will rise sharply. Who will want to hold a 10 Year Gilt paying 3%, when inflation is running at 5 or 6%?

A slowdown might cause a short run drop in prices to clear excesses, but lower demand does not cause lower market value for commodities. Those of us who experienced the stagflation of the 1970's and early 80's can well attest to that fact.

In fact, as economic activity falls, prices can often rise more, because unit production costs rise, which providing there is sufficient liquidity simply gets monetised into higher prices.

[Andrew]

What a great blog! - I've greatly enjoyed catching up a bit after a break. Thank you.

Noticed one small error (probably of the theory rather than Chris) in the post about Gareth Bath earlier this month.

"* Bale is, in a sense a (near) monopoly, and monopolies charge a price above marginal product."

1. All companies do and must charge a price above marginal product, or they would have no incentive to produce.

More interestingly:

2. Monopolies under perfect competition can't charge anymore than multipolies. Under this (obviously incoherent) theory the marginal market demand sets the price. A new unit produced by the monopoly is no different to a new unit produced by anyone else.

Think about it for two seconds.