Yellen Should Not Let Wages Be Her Guide

Everyone, it seems, is focused on wages: specifically, the failure of wages to endorse the 5 1/2-year-old U.S. economic expansion. Wage stagnation is the reason consumers are not more optimistic about their own or their children's prospects. It is the reason the public overwhelmingly supports an increase in the minimum wage. And it is the reason the Federal Reserve is keeping interest rates near zero.

It is the Fed's arguably love-hate relationship with wages that I wish to focus on here. Fed Chairman Janet Yellen views the paltry growth in real earnings (up 0.3 percent in the past year) as a sign that the 5.8 percent unemployment rate overstates the strength of the labor market. To policymakers, rising real wages would be a sign that the labor market has tightened sufficiently so that employers have to bid up the price of labor. Yellen and many of her colleagues would welcome such a development, at least initially.

Sharply higher wages would force businesses to raise prices to maintain their profit margins, triggering the dreaded wage-price spiral. 

This widely held view among economists about the causality between wages and prices happens to be dead wrong. Wages do not push up prices. Cost-push inflation is a relic of the days when unions held sway and employers were forced to accept their wage demands. Too bad the idea did not die with union power.

To be sure, the notion that wages push prices up has a certain intuitive appeal. Labor comprises the largest share of a firm's input costs, so when wages go up, firms have to raise their prices.

Empirical evidence supporting the idea is weak. You do not need an advanced economics degree or an econometric model (they may be a disadvantage) to understand the dynamic between wages and prices. Why would a businessman passively pay a worker more than his marginal revenue product, or what he contributes to the firm, and reduce his profits? That is something government might do; it is not how businesses operate.

The late Milton Friedman pooh-poohed the notion that costs push prices higher. In his view, an increase in money growth stimulates demand for goods and services, causing businesses to increase output and employment. Selling prices adjust quickly. Workers eventually realize that all prices are rising and demand a higher wage to compensate for inflation, which is the result of too much money creation relative to the goods and services the economy is able to provide.

The strong 1990s expansion, with its plunging unemployment rate (a low of 3.9 percent) and falling inflation, prompted a reexamination of the relationship between wages and prices. In a 2000 paper, "Does Wage Inflation Cause Price Inflation?", Gregory Hess, president of Wabash College and a member of the Shadow Open Market Committee, and Mark Schweitzer, director of research at the Cleveland Fed, found that prices and wages move together, with prices leading more often than not. They found little evidence that wages, either measured by compensation or adjusted for productivity (unit labor costs), are helpful in predicting inflation. Economists at Sweden's Riksbank reached similar conclusions, with a lot more equations. And wages are not a component of the Economic Cycle Research Institute's Future Inflation Gauge for the simple reason that they are not a good leading indicator of inflation.

Why focus on wages and prices now when much of the developed world is concerned about deflation, or a decline in economy-wide prices? As I said at the start, everyone is focused on wages—for different reasons. The real median income in the United States is still 8 percent lower than it was in 2007. Some of the reasons for sluggish wage growth are unique to the current expansion, including the creation of a preponderance of low-wage jobs; the still large number of part-time workers (10 percent more now than before the recession) and the gap in wage growth between full- and part-timers; the ability of U.S. companies to shift production to low-wage countries; and the greater share of compensation flowing to health benefits. 

The unsolved question is what to do about it. Faster economic growth, the obvious solution, remains elusive as economists debate whether potential GDP has slowed permanently, in which case cyclical solutions can only do so much. In the long run, an economy can only grow as fast as the growth in the labor force and productivity, neither of which is showing much oomph.  

For its part, the Fed seems determined to see wages rise before it begins to normalize its benchmark rate. Given the wide gap between zero and some neutral rate, waiting for a signal from wages will be too late. It may seem like a trivial point now, with neither prices nor wages posing any kind of an immediate threat. But when the economy is finally able to walk without assistance, it is important for policymakers, in particular, to know if they are looking forward or looking back.

Caroline Baum is a contributor to e21. You can follow her on Twitter here.

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