ULC, 1955-57, newsworthy inflation, and life as we know it

Wage-Price Dynamics: Are They Consistent with Cost Push? by Yash Mehra in the Federal Reserve Bank of Richmond ECONOMIC QUARTERLY, Volume 86, Number 3, Summer 2000.

I got distracted by ULC,  Unit Labor Cost. In the first paragraph, Mehra says:

Hence changes in productivity-adjusted wages are believed to be a leading indicator of future inflation.

Then, in the first footnote:

The term “productivity-adjusted wage growth” refers to wage growth in excess of productivity gains, measured here by growth in unit labor costs. The empirical work here focuses on this measure of growth.

Unit Labor Cost is calculated by leaving inflation in the numerator and removing it from the denominator. In effect they divide nominal labor compensation by nominal output, and then multiply inflation into the result. The deceptive arithmetic of ULC makes labor compensation appear to increase faster than it does in fact. It also skews the resulting values toward a path similar to that of inflation.

When the resulting values are compared to inflation and similarities are observed, people tell themselves that Unit Labor Cost is a useful tool and an excellent "indicator of future inflation."

People can tell themselves whatever they want, but ULC is fraudulent arithmetic and the comparison to inflation is bogus.

I go back now to the data, to Unit Labor Cost. As you will see, however, I do not compare ULC to inflation, find similarity, and use the similarity as evidence that wage growth has caused the inflation.

Graph #1: Unit Labor Cost in the Nonfarm Business Sector, 1948-1962

The context -- my reason for showing this graph and for focusing on the mid-1950s -- is the extremely rapid growth of the labor force in 1955 and the creeping inflation of 1955-57 which arose as a result of the labor force growth.

1. The extremely rapid growth of the labor force:

   

   Graph #2: 1955, the Most Rapid One-Year Increase in Labor Force Size, Bar None
   

   
   

2. The creeping inflation, which shows up in the CPI in 1956:

   

   Graph #3: The CPI, 1948-1962
   

Doublechecking inflation:

Graph #4: Price Index for Wages (blue) and Output (red) of the Nonfarm Business Sector, 1948-1962

From 1950 to 1952, wage inflation and output price inflation rise and fall together. Between 1954 and 1956, output price inflation rises to a plateau a year before wage inflation mimics that pattern.

The four dots on each line indicate the four quarters of 1955. Prices (red) start rising even before the dots, in the last quarter of 1954. The red dots are all above the zero line (meaning that prices were rising) and the red line is rising (meaning that the price increases were getting bigger) all through 1955.

For wages (blue) the first three dots are below the zero line: Wages were falling until the last quarter of 1955.

Again, the red line shows an upward sweep of prices from the last quarter of 1954 to the first quarter of 1956, and then runs between 3 and 4 percent for a year. The blue line shows an upward sweep of wages from the last quarter of 1955 to the first quarter of 1957, and then runs between 3 and 4 percent for a year. Wage inflation came a year after price inflation: the same pattern, but a year later.

Prices went up first. Wages followed. That's some kind of cost-push inflation. But it isn't wage-push.

During the inflation of 1950-1952, the Korean war-related inflation, prices and wages went up together. That was not any kind of cost-push inflation. It was demand-pull.

This topic keeps coming up because people say there is no such thing as cost-push inflation. But there is such a thing. I just showed it to you.

It keeps coming up because people say that even if there is cost-push inflation -- they call it "supply shock" inflation now -- the inflation doesn't last long because "shocks" are temporary. That came up in the news just the other day. Couple months in a row now we got newsworthy inflation. One of the news topics the other day was the question of whether this inflation now, in the months ahead, will be "temporary" or "sustained".

It matters because if the inflation is temporary the Federal Reserve won't do anything about it. They'll just ride it out. If the inflation is sustained, they will have to fight it. That is a change in thinking at the Fed. For many years, they thought they had to undermine inflation even before there was inflation, when inflation was only expected. Hm.

You might say the creeping inflation of 1955-57 was temporary. Compare it to the inflation of 1965-1984, which was sustained. In the process of slowing the economy to fight that sustained inflation, the Fed created recessions in 1969, 1973, 1980, and 1981 -- plus a "near-recession" in 1966. I'd guess they are hoping for temporary inflation this time around.

 

I started out looking at a paper by Yash Mehra, but I got distracted. So I jump now to the conclusion of Mehra's article to get the short version:

The cost-push view of the inflation process that is implicit in the expectations-augmented Phillips curve model assigns a key role to wage growth in determining inflation. In this article, I evaluate this role by investigating empirically both the presence and stability of the feedback between wage growth and inflation during the U.S. postwar period, 1952Q1 to 1999Q2. The results indicate that wage growth does help predict future inflation over the full sample period considered here.  However, this finding is very fragile, and it appears in the full sample because the estimation period includes the subperiod 1966Q1 to 1983Q4 during which inflation steadily accelerated.  Wage growth does not help predict inflation in two other subperiods, 1953Q1 to 1965Q4 and 1984Q1 to 1999Q2, during which inflation remained low to moderate. In contrast, inflation always helps predict wage growth, a finding that is both quantitatively significant and stable across subperiods. These results thus do not support the view that wage growth has been an independent source of inflation in the U.S. economy.

Pretty interesting. Not the easiest thing for a hobbyist to read, but interesting. Mehra is saying that the model is wrong, the model that "assigns a key role to wage growth" is wrong. That's definitely interesting.

Mehra's finding is that wage growth was driving inflation in the years of high inflation, the 1966-1983 period. And that wage growth was not driving inflation before or after the high-inflation years. This makes sense I think, because if wage demands are less vigorous, the inflation will be less vigorous.

Another point worth noting: If, as Mehra says, wage demands were not driving inflation in the 1953-1965 period, but there was inflation, then something else must have been driving it. And again in the 1984-1999 period, something other than wage demands must have been driving the inflation.

We need to know what that other cost is, so we can stop blaming workers and wages.

We need to know what that cost is, so we can reduce or eliminate the cost problem, as this is by far the best way to reduce or eliminate cost-push inflation.

And most of all we need to know what that cost is, so that we can reduce or eliminate the cost pressure that slows economic growth. Because civilization is like a shark. If it doesn't keep moving forward, it will die:

• Toynbee (abridged; 1946), page 10:
  

  "Why did the Barbarians ultimately break through? Because, when a frontier between a more highly and a less highly civilized society ceases to advance, the balance does not settle down to a stable equilibrium but inclines, with the passage of time, in the more backward society’s favour."

•  Quigley, 1979, page 141:
  

  "After  centuries  of  expansion  our  society  is  now  organized  so  that  it  cannot  subsist;  it  must  expand  or  it  will  collapse."

 

By the way, the "other cost" is the cost of finance. Excessive finance. (Just in case civilization still matters to you.)