Discussions over what’s in store for the economy and the markets inevitably turn to inflation. That’s a bit odd, considering that there’s none to speak of at the moment, at least according to official yardsticks. Consumer price inflation is rising at about 1% a year, according to the U.S. Labor Department, or near the lowest pace in decades.
One might expect that historically low inflation would banish worries over pricing pressures. But pondering the risk remains topical, as it was at a press briefing yesterday in New York hosted by Prudential that focused on the investment landscape for the year ahead. One strategist advised that the inflation threat continued to look subdued. “The odds of inflation picking up are very, very low,” said Ed Keon, managing director and portfolio manager for asset allocation, at Quantitative Management Associates, a Prudential unit. Why? Labor costs are falling, he told a capacity crowd at the Le Parker Meridien hotel’s Estrela Penthouse that overlooks Central Park.
A check with the Labor Department numbers confirms no less. Unit labor costs in nonfarm businesses slipped 0.1 percent in last year’s third quarter and are lower by 1.1% vs. a year earlier.
It all looks fairly cut and dry. Labor costs are falling, and so that translates into lesser inflation. A reasonable assumption, in part based on research that shows that labor costs generally account for around two-thirds of total business costs. If the biggest expense in the private sector is declining, inflation pressures must be waning, runs this school of thought.
Monetarists argue otherwise, invoking Milton Friedman’s famous quote: “Inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output.” Yes, although the relationship between monetary aggregates and inflation is complicated, particularly in the short term. But that’s an issue for another day.
Speaking of complications, the research literature on labor costs and inflation is nuanced too. The intuition for a relationship between the two comes from the Phillips curve, which posits that inflation and the unemployment rate are inversely correlated. In other words, an increase in the jobless rate is linked with lower inflation, and vice versa. But the empirical record on testing this idea is, at best, mixed.
“An important implication of price-type Phillips curve models is that prices are determined by the behavior of labor costs,” a 1990 study from the Richmond Federal Reserve advises. “If so, then labor costs should help predict the price level. The empirical evidence reported in this article does not support this conclusion.”
The case for skepticism about the so-called cost-push framework driving inflation is hardly the brainchild of one rogue analyst. A number of reports over the years have also cast doubt on the theory, including a paper published last year that argues that wage trends aren’t all that useful for predicting inflation. On the other hand, there does seem to be some evidence that the relationship works in reverse: inflation appears to forecast wage growth.
A few years ago, the Economic Policy Institute’s Jared Bernstein (who’s now Vice President Joe Biden’s chief economist) wondered if inflation and unit labor costs are a “phantom menace.” Maybe, but not everyone thinks the connection is feeble. A recent working paper by economist Farrokh Nourzad at Marquette University advises that unit labor costs are a “reliable indicator of price inflation.” In fact, there’s a global dimension to rising inflation via higher labor costs, a 2009 study from the European Central Bank asserts.
Fed Chairman Ben Bernanke has been known to embrace the concept of wage-based inflation as well.
But what should we make of the conflicting research on the question of whether labor costs drive inflation? Is this a genuine threat? Perhaps the answer is…it depends.
Labor cost inflation is cyclical, argues Anirvan Banerji of Economic Cycle Research Institute in a 2005 essay. “While there is obviously some rough correspondence between labor cost inflation and consumer price inflation, the question is whether, empirically, cyclical turns in the former systematically anticipate cyclical turns in the latter. If so, labor cost inflation would be an important predictor of consumer price inflation, validating the cost-push model of inflation.” But as he goes on to explain,
…labor cost inflation is not a consistent predictor of cyclical upswings and downswings in general consumer price inflation. As a result, analysts should use caution when interpreting cyclical swings in labor costs growth rates–as recent history shows, price inflation may enter a cyclical upturn before labor cost inflation does.
In other words, sometimes labor costs are critical factor in assessing the risk of future inflation, sometimes not. No one would accept such middle-of-the-road evaluations in aerospace engineering or plumbing. Economics, of course, is different.