Wage Pressure Is Not Inflationary

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by: Kevin A. Erdmann

The employment cost index for the first quarter continues to show some moderate strength. This has led to new discussion about inflation, etc.

I have written a few posts about the Phillips Curve - the idea that wage growth and inflation are related, or that rising wages lead to rising inflation. I don't think this relationship works the way it is generally described. Monetary inflation should certainly cause wages to rise just as it should cause all price levels to rise. Clearly there is causation going in that direction. I think the apparent causation going in the other direction is misleading. It is a matter of only feeling parts of the elephant.

One main piece of evidence that makes it look like rising wages lead to inflation is that firms report tight profit margins that are being squeezed by rising wages. They either have to raise prices or reduce profits. It seems likely that this would produce price pressure. The idea of cost-push inflation is alluring, but not useful.

First, there are two potential sources of wage pressure.

1) Rising capacity utilization.

2) Fundamental productivity growth.

On point 1, as unemployed workers return to the labor force and the pool of potential workers declines, there are pressures on wages. But, an economy running below capacity is not a productive economy. In this context, both wages and profits should rise, but this should be more than compensated for by the boost in productivity caused by utilizing productive capacity. Wage and profit growth should be real, in this context. If anything, this sort of growth should be disinflationary as real growth would be strong.

On point 2, it is difficult to grasp in real time the full complement of mechanisms that are in play. And, we will be more likely to see ailing, dying industries that we are familiar with than new, disruptive industries that are the source of new productivity. Here, also, it will appear that rising wages are inflationary, but they are not.

Here, it might be useful to think of Amazon (NASDAQ:AMZN) vs. brick and mortar book stores. Wage growth was strong in the late 1990s, and it would have been tempting to look at rising wages at brick and mortar book stores, and to forecast inflation. That is because those were mature businesses, so they had a very stable and understandable cost structure. Wages were rising, and they either had to raise prices or lose profits.

But, what we were seeing there wasn't price pressure. What we were seeing was productive transformation in an economy. What we were seeing was the end of a business model that wasn't profitable any more. When any business model comes to the end of its life because of new innovation and productivity, it will look like it is suffering from cost pressures. But, to the extent that those cost pressures were acute, they simply led to the transformation to new, more productive business models.

Amazon, on the other hand, was hiring like mad. And, nobody was looking at Amazon as a source of inflationary wages. That's funny, really. Because, since Amazon was young, they were not particularly profitable themselves. But, nobody looks at a young, disruptive company and says, "Oh, labor costs are cutting into their profits, this could lead to inflation." That's because Amazon wasn't trying to become profitable by cutting costs. They were trying to become profitable by hiring and growing.

There was a lot of that going on in the late 1990s. So, profits were low, wages were growing, and inflation was moderating. And, the stock market didn't seem too put out by the whole state of affairs.

By the way, interest rates were also high at the time, but they weren't high because the Federal Reserve was trying to discipline risk-takers by sucking cash out of the economy. They were high because investors were risk-takers, and so the safety of fixed income was not highly valued at the time. The appetite for risk wasn't expressed through borrowing. It was expressed through Amazon's rising stock price. It was expressed through expanding equity, not debt.

Rising wages are a sign of progress. They are something to be encouraged, not tempered. When wage growth is strong, real interest rates might naturally rise, but there is no reason to try to force them to in order to stop the business cycle.