Real wages & inflation

One thing that has peeved me recently is the claim that falling inflation is good for real wages. This is partially true, and partially false.

It's true in the sense that lower oil prices raise the real incomes of oil consumers. It's also true that a surprise drop in inflation of the sort we've seen can temporarily raise real wages.

However, in the longer-run, real wages aren't affected by inflation. If they were, we could achieve higher wages by (credibly) reducing the inflation target - but nobody believes this.

Instead, real wages depend upon real things like productivity growth and workers' bargaining power, and these aren't much affected by inflation: at moderate levels of inflation, there's no link between inflation and GDP growth, for example.  

This poses a danger - that, in the absence of real supports for real wages, the temporary benefit of lower inflation will be clawed back, in the form of lower future nominal pay rises.     

My chart shows the point. It plots the level of real wages (the average wage index divided by the CPI) against the change in real wages in the next four quarters. The relationship is clearly negative. This implies that a surprise rise in real wages because of, say, a surprise drop in inflation leads to lower future pay growth.

This could happen again. It's not just me that thinks so. Here are the minutes of the last MPC meeting:

It was possible that the fall in near-term inflation might become more persistent if it lowered inflation expectations, pay and other cost growth in a way that became self-perpetuating. Inflation had fallen globally and was expected to reach its trough in the United Kingdom in the early part of the year when a large proportion of pay claims were settled. It was therefore possible that the pace of nominal wage growth would be weaker than otherwise.

This is an especial danger because two big determinants of pay growth aren't terribly helpful.

For one thing, productivity is still awful. This week's numbers show that hourse worked rose by 0.5% in September-November. With the NIESR estimating that GDP grew 0.7% then, this gives us productivity growth of just 0.2%.

Secondly, it's not obvious how much bargaining power workers have. Yes, unemployment has fallen which strengthens their hand. But on top of the 1.9m formally out of work there are also 2.3m people outside the labour force who want a job and over 1.3m part-timers who want full-time work. This represents an excess supply of labour equivalent to 13.7% of the working-age population. This might continue to hold down pay growth.

To check this, I ran a quick and crude regression of reage wage growth since 2000 upon lagged unemployment (the official rate), the lagged level of real wages, and productivity growth. Such as equation has an r-squared of 69% since 2000. It tells us that, if productivity rises 1% in the next 12 months then real wages will rise 1.3% (standard error = 1.3pp). This is better than we've seen recently. But it's well below the 2.3% annual growth we saw in the seven years before the recession.

I don't offer this as a definitive forecast. Instead, I offer it as evidence that what matters for real wage growth is not inflation but more fundamental forces. And these aren't yet obviously very favourable.

Comments

[Ben]

The inflation figures don't reflect land price changes so inflation is far worse relative to wages.

"real wages depend upon real things like productivity growth and workers' bargaining power"

Inflation is a function of money supply and it's utterly detached from productivity growth because banks are being allowed to print money through land price inflation in a positive feedback loop as new loans set new prices.

They printed money through housing to be paid for with productivity that didn't come. All figures are a mess as inflation doesn't include land price inflation and yet the fresh money drives the perceived increase in "productivity". You econs are measuring everything in fiat and using the wrong inflator so all conclusions are just so far off the mark it's untrue.

Land prices and therefore rentiers are the problem.

[gastro george]

"Inflation is a function of money supply"

No. Inflation may result from and increase in the money supply, but only if the good that we are talking about is supply constrained. With your obsession about land, you ought to realise that.

Inflation in the rest of the economy is not a problem, as generally supply exceeds demand.

[rogerh]

Seems to me housing cost is key. Firstly the green belt - a vote loser until the young start waving placards. But more scarily what would happen to our economy if house prices ceased to be a one-way bet. Many are on the hook for a loss. Then there is 'productivity', a humanoid in the UK is directly comparable with a humanoid elsewhere, the difference is in the infrastructures surrounding them and the costs surrounding them. The humanoids' personal capital - at least the usable part - is now pretty similar in the usable places. So it is hard to see where significant improvements in UK productivity can come from, the cost/benefit curves are not favourable.

[bakho]

As most people have nominal debt that does not inflation, stagnant wages make that debt more difficult to pay back. This leads to less borrowing as it reduces the amount people can afford to borrow, and the amounts lenders will lend for long term purchases such as mortgages. The risk of default increases if prices are stagnant or falling.

Inflation needs to be high enough to accommodate the adjustments in relative prices and wages such that wages reset upward. Wages are sticky, and downward wage pressure is more likely to result in high short run unemployment. Downward wage pressure reduces demand and stifles economic growth.

The 2 percent inflation target for wages is too low and needs to be raised. Monetary policy has the target set too low. Inflation that is too low is only marginally better than deflation.

[Peter K.]

Yes workers' bargaining power needs to be increase in any way possible, to regain the losses that have occurred in recent decades. Part of it is tight labor markets via demand management policies (fiscal, monetary and currency).

Here is Dean Baker on why some economists call for a higher inflation target for our monetary-fiscal mix.

http://www.cepr.net/index.php/blogs/beat-the-press/economists-and-inflation-its-also-interest-rates-not-just-wages

Binyamin Appelbaum had an interesting post about how many economists would like to see a higher rate of inflation to help recover from the downturn. The piece emphasizes the role of inflation in lowering real wages, with the argument that lower real wages are necessary to increase employment.

While there may be some truth to this point, it is worth fleshing out the argument more fully. At any point in time, there are sectors in which demand is increasing and we would expect to see rising real wages and also sectors where demand is falling and we would expect to see real wages do the same (e.g. Wall Street traders -- okay, that was a dream).

Anyhow, when inflation is very low, the only way to bring about declines in real wages in these sectors is by having lower nominal wages. Since workers resist nominal pay cuts, we end up not having this adjustment and therefore we end up with fewer jobs than would otherwise be the case. However it is an important qualification in this story that it is not about reducing real wages for all workers, only for some subset.

The other important point is that higher inflation promotes growth in other ways. First and foremost it makes investment more profitable by reducing real interest rates. Firms are considering spending money today to sell more output (e.g. software, computers, Twitter derivatives etc.) in the future. If they expect to sell this output for higher prices because of inflation, then they will find it more profitable to invest today. If we can keep interest rates more or less constant and raise the expected rate of inflation, then firms will have much more incentive to invest. This process seems to be working successfully in Japan at the moment.

Finally, inflation reduces debt burdens. Everyone who has debt in nominal dollars, such as homeowners, students, state and local governments, and the national government, will see the real value of its debt fall in response to inflation. This reduces their debt burden and makes it easier to spend. This would likely also be an important source of demand growth from higher inflation.

While many economists do emphasize the wage story, to my mind the other parts are likely more important. And, if higher inflation leads to more employment, this will increase workers' bargaining power and allow them to achieve wage gains that are likely to quickly offset any losses due to inflation -- although the Wall Street traders may not make up the lost ground.

Addendum:

Let me make a quick comment to clear up unnecessary confusion (can't do much about the deliberate confusion). The notion of inflation being a way to lower wages in the U.S. refers to the wages of some workers, not all workers. There are always industries seeing increased demand and some seeing reduced demand. The response to the latter would be lower wages. That is difficult to bring about in a situation of near zero inflation and nominal wage rigidity. By having higher inflation so that real wages can fall in these industries, we can increase employment, output, and real wages more generally. That is the argument. Folks can say why that may not work, but it's really not worth anyone's time to deliberately misrepresent it so you can say it's stupid."