Will The Fed's 2% Inflation Target Help - Or Hurt?

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Includes: RINF
by: Gene Balas, CFA

Summary

The Fed's 2% inflation target is well known by now. But what are its effects on wages and profits? Higher inflation can erode both corporate profits and real wages.

The goal is that a company's revenues will increase in tandem with its costs. But that isn't always the case, and the difference is found in profit margins.

Historically, as corporate profits weaken, real (net of inflation) wages increase - but only to a point. After that, the relationship is reversed, perhaps as companies cut costs.

Then too, consider that higher inflation is inversely correlated with corporate profits. If we do have more inflation (reflected in input costs), will that slow hiring and wage gains?

Thus, higher inflation, even to a healthier level of 2%, has some potential to dent profits and wage gains.

As we all know by now, the Fed has a 2% inflation target, and the U.S. economy has struggled to achieve that. In fact, the Fed's preferred gauge of inflation, published by the Bureau of Economic Analysis, edged up just 1.1% in the twelve months through April. But what happens if we actually do achieve that 2% inflation goal?

Real Wage Growth

First consider that, in nominal terms, wage growth has been modest at best, and weak enough that it is an issue that Fed officials and many private economists have pondered. But these modest nominal gains translate into real wage growth that is actually roughly in the range where we have been over the past several years. Since real wage growth is nominal wage growth minus inflation, the more inflation we have, the lower real wage growth would be.

The hope is that businesses would generate higher sales in nominal terms with more inflation, and share those revenues from price increases with workers in tandem. As unemployment has fallen and the labor market has tightened - most notably for skilled workers, as college graduates have an unemployment rate of just 2.4%, per the Bureau of Labor Statistics - some workers might eventually command higher pay.

However, despite some signs of rising nominal wages, we are not there yet. The employment cost index for wages and salaries increased 2.0% for all workers in the twelve months to March 2016 (these data are published quarterly by the Bureau of Labor Statistics). This is down from a 2.6% yearly increase to March 2015 and a 2.1% increase in December 2015 - a trend in the wrong direction.

What Happens if Inflation Increases?

Let's now ponder what happens if inflation increases somehow. Might it be due to things that don't actually benefit companies' bottom lines, like a falling dollar that drives up import prices and also sends commodity prices higher? That could happen if the Fed fails to raise interest rates, and assuming foreign conditions at least remain stable, then the Fed might achieve its 2% inflation goal. However, this scenario would affect companies' costs, and they then may attempt to pass through at least some price increases to customers.

But what if a business's costs increase more than it can increase selling prices to its customers? An inflation target rests on the assumption that costs and prices move in tandem, but they often do not. The difference is reflected in a company's profit margins. Not surprisingly, more profitable companies have more funds to hire, invest and grow. Less profitable companies do not.

And here we get to the crux of the issue: as workers' compensation grows in real terms, corporate profit growth slows or even turns negative. As seen in the nearby graph, there is a neat, inverse relationship between year-over-year corporate profit growth and real wage growth.

The relationship between profits and real wages Click to enlarge

Profit Growth vs. Real Wages and Inflation

Profit growth falls as real wage growth increases. Then, often mid-way through an economic expansion, the direction shifts, and profit growth increases and real wage growth decelerates. Based on this relationship, as profit growth has reached a nadir, we may infer that employers may begin to cut costs and limit pay raises for workers. Given that corporate profits have fallen in the past two quarters from a year ago, according to data from the Bureau of Economic Analysis, could we have the same relationship now, as witnessed by the weak job growth in the past two months?

Now, consider the relationship between profits and inflation. (Remember that real wages have already had inflation subtracted.) There, too, is an inverse correlation. Higher inflation rates tend to result in lower profit growth. This may mean that, at some point, a business may find pricing power is limited, while input costs increase. If we do see inflation accelerate to the Fed's 2% target, will we see even weaker corporate profits?

Profits and Inflation Click to enlarge

Conclusion

Thus, sequencing the relationship between profits, inflation and real wages, if we do see inflation accelerate to the Fed's 2% target, then conceivably corporate profits could falter if input costs rise faster than the prices commanded for goods and services sold. If corporate profits weaken further, companies may hire fewer people and dole out fewer pay raises to existing workers.

As such, while there may be benefits to higher inflation - it does make debts easier to repay, especially when the original loan terms were predicated on a certain rate of inflation - there may be downsides, too. In sum, the old adage, "Be careful what you wish for", may apply.

Disclosures

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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.