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The Limits Of The Pass Through Model In Times Of Wage-Price Stickiness

Price recovery is fundamental to any economy and we have seen so far a lukewarm response for a basket of products and services. As for the aggregate economy this works through the CPI and we have seen a rather dampened one and it would be rather unusual for a recovery to be stymied for such a long time (almost two years now).

Stickiness of price invariably has many components to be looked at and for an economy like U.S. we have a number of leading indicators to be looked at as well. We have seen exports picking up for a while but imports have not fared badly as well. Some industries have done exceedingly well, in the technology sector and in services and financial areas; those that are capital intensive have not done so well and those which are connected to commodities other than oil have fared the worse.

The same economy has meant different things to different sectors; the financial for example has been booming like the pre-recession times. So we need to look at the pricing side of the story.

The BIS paper 409, Wage & Price dynamics in a large economy, talks about an apparent disconnect in the pass-through mechanism of wage to prices in an economy like China. With rise of collective bargaining which took off in a big way in the 1990s is now well entrenched in the Chinese system and the wage increases are fairly regular and steep. The pass through of wage does not flow to the final price, as it would have reflected adversely in the CPI and we have seen not such a pronounced effect in the CPI given the high growth rates in China.

The only way this could happen is through a squeeze in margins and in turn the profitability of the companies. This has been highlighted as the most potent reason which has dampened the pass-through model to work. Perhaps this is one example of the residual social equity in a predominantly capitalist China.

U.S. on the other hand has a complete pass through and any wage increase reflects directly in the prices and profitability. So if U.S. companies are doing well in a regime where prices cannot move up, it can only do so through productivity growth or through a reduction in per unit wage; probably both the reasons are equally likely.

But it is quite an overlooked fact that the industries which are doing well are the ones which can pass-through better than the others or are so differentiated in their offerings that they can still command prices where it goes beyond the limits of a pass-through model.

Let me take the worst examples first, where the pricing power is not in the hands of the industry alone like in Metals, Oil & Gas and other commodities where international prices are determined by a host of macro-economic factors, all of which are dampened at the moment due to demand factors. In these industries any wage rise directly reflects in the lower margins and profitability as the pass through model does not work. It is only when these industries move to the value added model where they start to muster pricing power and the ability of pass-through.

Those industries in the technology sector where high level of technology sophistication and innovation has been achieved, the pass through model works very well and the pricing power has shifted from the consumer to the supplier.

Also when high level of competition leaves finally just a few players in the fray, pricing power rises as is the case with big banks; but banks have more than that reason as the cost at which banks have access to funds for credit is just a fraction of what they charge the clients, proprietary trading comes on top.

The limits of pass through model in the macro-economic framework becomes visible when we see on one hand huge stimulus money following those sectors which are already hugely profitable, while making a fleeting entry into those who have almost no pricing power and where the pass through does not work as it would tantamount to rise of end product prices in an environment where demand is dampened.

This leads us to the question of credit mis-allocation, when a few sectors prosper at the cost of the other and there is no net gain for the society as a whole. It is only when the pass through model works in a competitive environment that we could see recovery of prices; that would force wages to move from its stupor of steadfastness much to the elation of one and all.

Procyon Mukherjee

9th April 2013