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Home Publications Blogs Beat the Press The Fed, Inflation, and Wages

The Fed, Inflation, and Wages

Tuesday, 29 October 2013 04:49

If the Fed were to pursue a policy of deliberately promoting a higher rate of inflation, it is not necessarily the case that the higher inflation would precede a rise in wages, as suggested in Binyamin Appelbaum's Economix post. The point of a higher inflation policy is to convince businesses that prices will be higher in the future than they would have thought otherwise. For example, if they expected 1.0 percent annual inflation, they would think that prices would be 5 percent higher in 5 years than they are today. If the Fed manages to convince them that inflation will average 2.0 percent, then they will think that prices will be 10 percent higher in 5 years. (I've ignored compounding for simplicity.)

This should not cause businesses to directly raise their prices. If they thought they could raise their prices, they presumably would have already done so. Rather, it would likely change their investment behavior. They know what it costs to invest in new machinery, research and development, new software, etc. If they think they will be able to sell the products that come from this new investment at a higher price in the future, then they will be likely to undertake more investment today.

This would increase investment in the economy and also the demand for labor. Businesses would also be prepared to pay higher wages to workers to carry through this investment. This would allow them to pull workers away from other firms, as well as hiring currently unemployed workers. If this led to upward pressure on wages, all firms would be seeing higher costs, which then lead to the higher prices that the Fed was trying to bring on. By this logic, higher inflation is the result of higher wages. Therefore, there is little basis for concern that wages on average will not keep pace with inflation.

Of course this will not apply to all workers. Some workers will not be in a position to ensure that their wages keep pace with inflation. These workers will be losers from this policy. This is unfortunate, but there are two points to keep in mind.

First, the reason some workers will not be a position to have wages keep pace with inflation is that there is little demand for their labor. In other words, these are workers who are already in a precarious position. A somewhat higher inflation rate (e.g. 3-4 percent rather than 1-2 percent) may cause their real wages to fall more rapidly than they would have otherwise, but they likely were on a downward path already.

The second point is that we don't know how to carry through economic policies that don't result in some people losing. For example, if we have a great new infrastructure project for high speed rail or fast Internet, then people will lose jobs in businesses that were associated with the old modes of transportation or Internet (e.g. restaurants and gas stations along the highway). In some cases, we opt not to think about the losers, but that is a political decision, not a result of having a policy that doesn't produce losers.

We need safety net policies such as unemployment benefits that protect losers, but if a requirement of economic policy is that it have no losers, then we would have to give up on economic policy.



The folks worried about how inflation will leave most workers worse off need to figure out a theory of where the inflation is coming from. I gave a story where the expectation of higher future prices leads firms to increase investment, hiring, and wages, which could then make the expectation of higher inflation self-fulfilling. If we don't see this additional hiring, investment, and wages, then it is difficult to see the process through the Fed can bring about a higher targeted rate of inflation.

Of course if inflation does comes through this channel, then we don't have to worry about wages keeping up with inflation, higher wages will have caused the inflation. Again, not everyone's wages will keep up, but welcome to the world. If increased direct hiring of workers led to a higher rate of inflation, then some workers wages will also not keep up. Should we therefore be fervent supporters of keeping high unemployment forever?

Comments (18)Add Comment
Wage Inflation
written by bakho, October 29, 2013 5:43
We need wage inflation. Raising the minimum wage would help.
When Expected Future Income Increases, So Does Present Income
written by Last Mover, October 29, 2013 6:18

Bottom line:

It's about future versus present aggregate output and income in a macro context designed to address massive unemployment.

Concern about losers around the edges is silly given the huge gains of employing the currently unemployable by closing the $1T output gap, some of which can be used to compensate losers as necessary.

Most concerns about inflation are flawed because they are presented in a full employment context combined with unrealistic assumptions that imply money is fully transparent and neutral in the long run in its effect on real output, while highly destructive in the short run.

Not so here. As Dean Baker explains, it's the aggregate effect of using intentional inflation to change the difference between expected future income compared to present income necessary for the private sector to break out of its current stagnant condition of insufficient investment spending.

That means everyone wins, not just some over others. If it worked out perfect no one would win more than another in real terms except the unemployed compared to the employed ... and non-debt holders over debt holders.

This needs to be rubbed in the face of the economic illiterate naysayers over and over as they slink around in their zero-sum irrelvant micro world warning of the hyperinflation that never comes.

And that includes wealthy holders of debt who know exactly what's going on and are against increasing employment to avoid losses to the real value of their debt.
A Full-Employment Economy
written by Tyler Healey, October 29, 2013 7:33
I think we can produce an economy in which there is no long-term unemployment. Innovation may sometimes cause people to lose their jobs, but a generous safety net would both keep the unemployed out of poverty and stimulate the economy so they can find another job soon.
written by artichoke, October 29, 2013 7:58
"if a requirement of economic policy is that it have no losers, then we would have to give up on economic policy." If there is no economic policy, big corporations and other powerful forces do whatever they want, and there are lots of losers. Absence of policy is itself a policy.
written by skeptonomist, October 29, 2013 9:03
Dean engages in even wilder speculation than usual on the subject of central banks trying to increase inflation. He and Krugman spend a large part of their time arguing that the current problem is lack of perceived demand, but then when it comes to monetary policy that is thrown out the window in favor of rank conjecture about the effect of variables, inflation and interest rates, which are known not to be important at the moment in the minds of businessmen.

The NFIB poll among others shows that inflation and interest rates are not concerns to businessmen - what they are waiting to see is increase in demand. As I have said before, if prices go up, the initial result is that demand will go down because workers will have less to spend. As I have also demonstrated before, historical evidence clearly shows that wages do not automatically go up as inflation increases, and under conditions of low employment there is no theoretical reason for them to do so. Are businesspeople so stupid as not to be able to anticipate the immediate effects of inflation on demand? There is no evidence that they engage in the kind of convoluted calculation that Dean describes - what we know is that when they see demand increasing, they will increase investment.

There is no empirical evidence that inflation itself improves economic conditions. Favorable conditions for workers have been associated with inflation in the past, especially during wars, when governments have been spending lots of money, the work force has been reduced by conscription and production of consumer goods has been reduced. Then wages naturally tend to go up along with prices. The causation of all this can't be reversed by decree of the Maestros.

What would increase demand, and incidentally probably increase inflation somewhat, is increased government spending. Indulging in unfounded speculation about untested monetary-policy action just diverts attention from what needs to be done.
"Absence of policy is itself a policy"
written by Jennifer, October 29, 2013 9:03
@artichoke EXACTLY

"We need safety net policies such as unemployment benefits that protect losers, but if a requirement of economic policy is that it have no losers, then we would have to give up on economic policy."

What is telling is who the losers are-the constant frame of the media is that what is good for corporatations/the 1% is good for everybody, but this is simply not true. The status quo definitely favors those who already have everything. But the status quo is usually framed as "neutral".
written by skeptonomist, October 29, 2013 9:10
Here again is the historical record of inflation and wages:


Since the end of WW II, there is an obvious strong anti-correlation of the growth of wages with inflation. When inflation increases, wages fall behind.

Wages are for the category of "production and nonsupervisory" workers tracked by the BLS, but other categories are similar.
written by David M, October 29, 2013 9:19
@skeptonomist, the reason why Dean, Krugman, et al don't talk as much about stimulating demand through fiscal policy is because it would be utterly fruitless given the current political situation. Congress and Obama have both made it clear that cuts, not stimulus, are the order of the day. The Fed has at least given lip service to reducing unemployment, so it's a better use of time trying to explain how monetary could do that.

It's the same reason why Dean talks about importing doctors more than enacting a single payer plan. Both would help reduce healthcare spending. Only one has any chance of happening in the foreseeable future.
Federal Spending
written by Tyler Healey, October 29, 2013 9:20
Federal spending would increase demand, but the House is controlled by Hooverites who do not accept this fact.

Perhaps QE should be ended, as it brings down interest rates and thus reduces the size of the federal government's interest payments.
written by Avante Guard, October 29, 2013 9:49
What if businesses thought inflation was going to increase and bought new equipment and software but then the expected inflation didn't show up.

Isn't that the story of the past few years, when strong business investment balanced out weak PCE? But inflation instead of rising has fallen and now businesses are not getting the return from the investments because revenue has not risen as much as they expected.

Are we going to keep whipping the dead horse of business investment, yelling 'Inflation, inflation!' as if it were a magic word to conjure economic growth?
Oh, oh...
written by medgeek, October 29, 2013 9:55
"The second point is that we don't know how to carry through economic policies that don't result in some people losing."

Vilfreto Pareto is rolling in his grave...
written by medgeek, October 29, 2013 10:01
that should be "Vilfredo"
written by skeptonomist, October 29, 2013 10:49
I think Krugman actually pushes the idea of "monetary credibility" and the hypothetical benefits of inflation because a) it is his very own special idea; and b) he and other economists are unable to give up the general idea that monetary policy is or could be the controlling factor in the economy. One reason that fiscal policy has been neglected is that economists essentially promised that monetary policy could do the job with no political complications or need for politically-negotiated regulations - just put things in the hands of the technocrats or Maestros. This overoptimistic attitude towards monetary policy was at its zenith during the 60's and 70's after the publication of Friedman and Schwarz and works by Paul Samuelson, but most of the premises have been falsified since then - the Fed has not been able to control inflation or prevent recessions. But most of today's dominant economists or their mentors were trained during that time, and those premises are still in the textbooks.

Nothing is gained by pushing remedies that have little or no chance of working. Dean Baker, Paul Krugman and many others think that fiscal policy would work, so they should be putting all their weight behind that. If economists' opinion have no weight in politics they should probably go back into their ivory towers where political influence is less likely to disrupt real scientific work.

If politicians oppose fiscal stimulus and favor austerity they also oppose inflation - actually for some good political reasons. If prices actually started rising and wages did not keep pace - and they would not under current conditions - there would be tremendous political pressure on politicians and in turn on the Fed to change policy.
written by Dean Kisling, October 29, 2013 10:58
How does the argument that holders of debt do not want higher inflation because it reduces the real value of the future payments that will be made to them -- fit into this?
interesting speculation, not following the article
written by pete, October 29, 2013 10:58
The Akerloff model (Yellen and Akerloff) is what I think folks like Rogoff are focussing on. Traditional Keynesian. Wages are too high. Ever Jared said so, reluctantly. To get them down, in real terms, inflation seems to be the poison of choice. Firms hire more workers when the value of the output is higher than the cost...it isn't rocked science.

During the crisis, the immedicate effect was a fall in profits, without a corresponding fall in wages, ergo, layoffs. As skepto points out, inflation has been very bad for labor, it never catches up. Great for capital, bad for labor. Keynes was not a socialist. Unions used to be anti inflation for exactly this reason, they figured it out. Not sure when this flipped over to monetary policy being a liberal idea. Good marketing I guess.
written by fresno dan, October 29, 2013 12:10
"Of course this will not apply to all workers. Some workers will not be in a position to ensure that their wages keep pace with inflation. These workers will be losers from this policy. This is unfortunate, but there are two points to keep in mind. "

OK Mr. Free Trade economist - 40 years of the 99% getting the shaft and not keeping up with inflation. Why do you believe in these upcoming bout that will change????
written by PeonInChief, October 29, 2013 12:52
Most workers are in a precarious position and the distinction will be between those who have to pay inflated prices with non-inflated wages, and those who lose their jobs altogether. As for the safety net, it would have to be a lot stronger than it is to protect even employed workers. And that ain't gonna happen.
written by watermelonpunch, October 30, 2013 12:44

Wow, what a page of Debbie Downer-ism.
(With a couple of exceptions, of course.)

Just because there's some unpleasant reality to deal with, hardly means people here reading this (and commenting) need to just accept the shittiest of all possibilities, and conclude that all is despair and hopelessness, and deride anyone who offers a suggestion of a hopeful solution.

Should y'all go on overpriced anti-depressant drugs?
Or maybe we should go back to the time that it was rather common for humans to make sacrifices of other humans hoping for a good harvest, because well, that ain't never going to change, is it?

Boo hiss on the Debbie Downers!

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.