Wages and inflation

Will faster wage growth lead to higher inflation? Discussions of wage and price spirals are in the news, but by comparing the growth rates of wages and prices, one can lose sight of what is going on with the levels. Real wages – the level of wages relative to the price level – are what matter for those receiving labor income. And what has happened to real wages during the past two years of above target inflation depends very much on which price index one uses to deflate nominal wages.

The Fed’s preferred index for measuring inflation is the personal consumption price index less food and energy prices, called core PCE). The PCE index does a better job of capturing how household substitute away from goods whose prices have risen more than average and away from goods whose prices have risen less than average. The ability to substitute across goods helps to mitigate the effect of inflation on households’ budgets. Eliminating the prices of food and energy, which tend to be volatile, can also give a better picture of future inflation. Using core PCE to deflate the BLS’s series on average hourly earnings yields an estimate of the real wage that is shown in blue in the figure. All data are monthly, seasonally adjusted and obtained from the St. Louis Fed’s FRED database; series are normalized to equal 100 in January 2020. The real wage series based on the core PCE price index suggests wages have kept up with inflation. Real wages spiked during the COVID recession and then dropped in its aftermath, but the measure has remained essentially flat since June 2020.

However, core PCE is not the only way to measure inflation. A more common measure of inflation, so common it is sometimes referred to as headline inflation, is based on the Consumer Price Index (CPI). This index does not do as good a job as the PCE does in incorporating how households shift their spending patterns in response to changing prices. Substituting to cheaper alternatives may cushion the impact of inflation, and this margin of adjustment is better captured by the chain-index PCE inflation measure, but the fact that a household needs to make such a substitution may make the price rise more salient in the household’s assessment of their cost of living. If so, CPI inflation might better capture how households assess the impact of inflation on their living standards. The red line in the figure shows what has happened to the real wage when the CPI is used instead of core PCE. The CPI-based real wage shows a steady decline between June 2020 and June 2022. Since August 2022, the CPI measure of real wages has remained essentially flat at a level approximately 4% below its June 2020 level.

Which measure of real wages might be most relevant for foretelling future wage growth? According to a Gallup Poll (April 6, 2023), inflation remains the top economic concern of Americans in 2023 as it was in 2022, with the fraction of respondents citing inflation as something they worry about “a great deal” coming in at 59% in 2022 and 61% in 2023. The number citing unemployment as something they worry about a great deal was just 32% in both 2022 and 2023.

It seems hard to reconcile how many American are worried about inflation with the stability of the real wage based on the Fed’s preferred price index. The decline in the CPI-based real wage seems much more consistent with the Gallup data. If this is the case, greater pressure for wage growth that is sufficient to boost real wages seems likely.

Bank of Japan IMES Special Trialogue (Part 3)

The Institute for Monetary and Economic Studies (IMES) at the Bank of Japan, to mark its 40^th anniversary, recorded three conversations in October 2022 on central banks, research, and monetary policy in which I participated, together with Athanasios Orphanides (my fellow Honorary Adviser to the IMES) and Deputy Governor Masazumi Watakabe. The third of these conversations, focusing on “An important role of central bank economists for communication”  is now available at https://www.imes.boj.or.jp/en/newsletter/nl202302E1_s3_r.html#t00.

Deputy Governor Watakabe opened the conversation by asking “In what ways do you think central bank research is relevant to or useful for communication purposes?” This is, of course, a key question and goes to the heart of why central banks have research departments.

Athanasios emphasized that a central bank needs to “explain what it is doing and why it is operating in a specific way. But to effectively respond to these public debates, it's very important to have central bank economists who understand academic research and translate that into the language that is understood by the community.”

In my response, I agreed and noted the importance of inflation targeting in facilitating clear communications of policy making by providing an explicit focus, the central bank's inflation objective, around which policy actions can be explained. But I also stressed the importance of not overselling what monetary policy can achieve.

The conversation turned to how central bank economists, through research on their own countries, can help distill and share lessons that as, Athanasios put it, “help identify best practices and build the global regulatory framework.” I noted in this context the important early work on the effective lower bound (ELB) on policy rates by Japanese economists which subsequently became relevant for a much broader set of countries after the global financial crisis. The experiences with attempting to manage expectations at the ELB and, more recently, with increased rates of rates of inflation, even in Japan, have focused attention on the need to better understand inflation expectations. This is an area where research by IMES economists using survey date from, for example, the Tankan survey of several thousand private firms conducted by the Bank of Japan, are making contributions to an important topic of interest to both central bank and academic researchers.

Athanasios highlighted the impact of demographics on economic growth as another area in which Japan is at the forefront. He suggested that, as was the case with the ELB, research that draws lessons from the Japanese experience is likely to be of increasing relevance to many other countries.

Policymakers at central banks face many challenges in  implementing successful monetary policy . A strong research staff can help policymakers in meeting these challenges by offering new insights into the effects of monetary and regulatory policies, distilling the latest advances from researchers around the world, and accessing how best to communicate policy actions to the public.

Bank of Japan IMES Special Trialogue (Part 2)

 

The Institute for Monetary and Economic Studies (IMES) at the Bank of Japan recorded three conversations on central banks, research, and monetary policy in which I participated, together with Athanasios Orphanides (my fellow Honorary Adviser to the IMES) and Deputy Governor Masazumi Watakabe. 

On February 27th, I posted a link to the first of the three conversations which covered "Interactions between Central Banks and the Academic Community." The second of the three discussions, which focused on "Art and Science in the Conduct of Monetary Policy" is now available at https://www.imes.boj.or.jp/en/newsletter/nl202302E1_s2_r.html

In this conversation, I stressed that "...monetary policymaking must be based on firm science, but in the application, it's not a cookbook process where you just follow the directions..." The global financial crisis, COVID, and the war in Ukraine are examples of situations in which central banks found themselves facing new and unexpected challenges, and I concluded that "The implications of all those things are uncertain at the time and there is no model that would tell you exactly what you should do. In such cases, you need good people with good judgement."

Athanasios pointed out that, while I had started out by talking about science, I ended up by emphasizing judgement. He went on to argue that "...good public policy must be based on solid analytical foundations and measurement." He concluded that "...judgement is required in the situation when there is not enough data nor information to give clear evidence. In that situation, the policymaker by necessity must combine available pieces of information with his or her personal experience and knowledge and come to a good conclusion."

Dealing with uncertainty requires judgement. Deputy Governor Watakabe suggested an "...analogy is between science and technology, rather than between art and science." He noted that just as engineers have to design systems that are robust in the face of uncertainty, economists at central banks must do the same. "Central bank economists are expected to be good engineers." 

From there, our conversation moved on to discuss the role of expectations and the types of data central banks need as they seek to understand the economy and design policies. 

The third conversation in the trialogue deals with "The Role of Central Bank Research in Communications" and will be featured in a future post.

Bank of Japan IMES Special Trialogue

To mark the 40th anniversary of the Institute for Monetary and Economic Studies (IMES) at the Bank of Japan, I participated in a discussion with Athanasios Orphanides (my fellow Honorary Adviser to the IMES), and Deputy Governor Masazumi Wakatabe that touched on three questions: 1) Interactions between central banks and the academic community; 2) Art versus science in the conduct of monetary policy; and 3) The role of central bank research for communications.

The first of these discussions is now available at https://www.imes.boj.or.jp/index.html?lang=en&page=7&id=#07&src=.\en\newsletter\nl202302E1_r.html. In it, Athanasios and I review the evolving relationship between academics and central bank economics, focusing on the U.S. experience. In my comments, I noted how much this relationship has changed since I began my professional career almost 50 years ago. In the 1970 and 80s, standard models stressed that policy surprises were what mattered for the real economy. Any systematic, predictable monetary policy was irrelevant for business cycle behavior. These models were not well posed to offer guidance on how systematic monetary policy could contribute to stabilizing the real economy. That changed with the adoption of the new Keynesian model, which provided a common framework for academic and central bank researchers to contribute to policy-relevant issues.

In his comments, Athanasios stressed that “…research is essential for understanding what has gone wrong in the past. Sometimes it takes decades to understand why some major economic disasters happened and research is what guides us to improve policy.” He used the Great Depression as an example, noting that it took two decades after the publication of Milton Friedman and Anna Schwartz’s Monetary History of the United States before it was recognized in the profession as the best explanation and understanding of what had gone wrong with Federal Reserve policy during the Great Depression.

Incidentally, Milton Friedman and James Tobin were the first two Honorary Advisers to the IMES. I stepped down as an Honorary Adviser in December; Markus Brunnermeier of Princeton University took on the role in January. A complete list of all the Honorary Advisers since 1982 can be found at the Institute's web site at https://www.imes.boj.or.jp/en_about.html

Confusing the price level and the inflation rate

Isn't it annoying when the price level and the rate of inflation are confused? Or when bringing down the inflation rate is confused with reducing the price level? See my recent (Feb. 20, 2023) letter in the FT: https://www.ft.com/content/e7fff27b-0c10-47a7-b9a0-d6470b80c68c. (Subscription may be needed.)

In memory of Ben McCallum

Bennett T. McCallum died December 28, 2022. Ben was a major contributor to macro and monetary economics, with important publications spanning 40 years. While his work touched on many topics, his papers on equilibrium determinacy in rational expectations models, monetary policy, interest rate rules, and the importance of robustness in designing policy rules were, I think, his most important. He offered insights into the theoretical implications of general equilibrium monetary models under rational expectations as well as practical guidance to the evaluation of policy rules.

My first interaction with Ben was when he was a discussant of the paper I presented at the 1982 Federal Reserve Bank of Kansas City Jackson Hole Symposium. Far from filling the large meeting room just off the Jackson Lake Lodge's lobby as it does now, in 1982 the whole event was held downstairs in modest room that felt like a basement.

It is interesting to look back at the 1982 Symposium and see what has changed and what has remained the same in terms of the featured topics. On the first day, Alan Blinder presented "Issues in the Coordination of Monetary and Fiscal Policy," and John Taylor presented "The Role of Expectations in the Choice of Monetary Policy," topics still discussed today.  The next day I offered a paper on "The Effects of Alternative Operating Procedures on Economic and Financial Relationships,"  Ed Kane presented "Selecting Monetary Targets in a Changing Financial Environment," and Ben Friedman presented "Using a Credit Aggregate Target to Implement Monetary Policy in the Financial Environment of the Future.” The second day papers reflected the debates of the time over instruments and targets for monetary policy. Nowadays it is taken for granted that central banks employ a short-term interest rate as their policy instrument and that targets should be for goals such as inflation, not for alternative definitions of reserves or monetary aggregates.

In looking back over Ben's discussion of my 1982 paper, I was struck by his concluding comments: "...recommending the use of equilibrium models is not the same as asserting that the behavior of the economy is well-described by flexible-price equilibrium models. As Taylor's (1982) paper for the conference points out, these models are difficult to reconcile with the data. What is needed is an extended equilibrium analysis that explains the existence and nature of nominal contracts and thus predicts how they will respond to changes in policy…The virtue of the equilibrium-analysis program is that it provides a particular form of analytical discipline, i.e., it encourages one to think carefully about the behavior of individual agents and about the way in which the actions of many such agents interact. This discipline is valuable...."

Recall that 1982 was the year Kydland and Prescott published "Time to build and aggregate fluctuations,” (Econometrica, 50:1345-1370), providing the foundation for real business cycle analysis based on equilibrium modeling approaches. Ben stressed that the use of equilibrium models did not preclude introducing nominal rigidities that both facilitated the study of monetary policy rules and helped to fit business cycle data. Since the early 1980s, economists in the new Keynesian tradition have made great strides in extending our understanding of the role of nominal rigidities. However, the profession has been less successful in addressing Ben’s call for explaining the existence of such rigidities.

Here is a very short and selective set of some of Ben’s important papers; the titles give a good sense of some of the topics he worked on:

McCallum, B.T. 1981. “Price Level Determinacy with an Interest Rate Policy Rule and Rational Expectations.”  Journal of Monetary Economics 8:319-329.

McCallum, B T. 1983. “On Non-Uniqueness in Rational Expectations Models: An Attempt at Perspective.” Journal of Monetary Economics 11 (2): 139–68.

McCallum, B.T. 1986. “Some Issues Concerning Interest Rate Pegging, Price Level Determinacy, and the Real Bills Doctrine.” Journal of Monetary Economics 17 (1): 135–60.

McCallum, B.T. 1988. “Robustness Properties of a Rule for Monetary Policy.” Carnegie-Rochester Conference Series on Public Policy 29: 173–204.

McCallum, B.T. 1999. “Issues in the Design of Monetary Policy Rules.” In Handbook of Macroeconomics, edited by J Taylor and M Woodford, 1483–1530. Vol. 1C, Amsterdam: Elsevier North-Holland.

Inflation surges in perspective

 

This week’s FOMC statement and Chair Powell’s press conference rightly stressed the progress that has been made in controlling inflation, and the U.S. does seems to be past the peak of the inflation surge of 2021-2022. Powell was correct, however, in stating that it is too early to claim victory. To offer some perspective, this post looks at other inflation surges over the past 50 years.

Figure 1 shows U.S. inflation over the period 1960 to 2022 as measured by the percent year-over-year change in three different price indices: the consumer price index (CPI), the personal consumption index, the personal consumption index (PCEPI) less food and energy prices (PCEPILFE), and a measure of the prices of sticky goods and services prices constructed by the Federal Reserve Rank of Atlanta (it also excludes food and energy prices). All data is obtained from the St. Louis Federal Reserve Bank’s FRED database. https://fred.stlouisfed.org/.

The figure suggests four inflation-surge episodes, three of which occurred between the late 1960s and the early 1980s, a period that encompasses the Great Inflation. The first two surges were quickly followed by another and larger upward surge in inflation. After the third surge, which peaked in June 1980, CPI and Sticky CPI inflation started rising again, reaching a second peak in Sept. 1981, but thereafter all four inflation measures continued to fall as the economy entered the period of the Great Moderation.  

The fourth surge in inflation that stands out is the one in 2021-2022. 

The second figure isolates the four inflation surges. The mid-1970s and late 1970s cases (in the upper right and lower left panels) are the most interesting from today's perspective. Both were associate with oil shocks. In both cases, CPI inflation, which includes food and energy prices, dropped relatively quickly. In the case shown in the upper right panel, inflation fell, but not back to its starting level, before rising again, leading into the inflation surge seen in the lower left panel. 

The question now is whether the current inflation surge, seen in the lower right, will follow the pattern of the early 1980s, with inflation eventually stabilizing around a low level, or whether it might be 1976 again, with only a temporary decline, followed by an uptick in inflation. And even if there is no uptick, will it decline to rates similar to when the surge started, as with the first surge in 1970 (upper left panel), stabilize at the Fed's 2% target, or halt at a higher rate, perhaps around 4% as some have advocated?  

In his opening remarks at the press conference following the FOMC meeting February 2, 2023, Chair Powell stated that, in the fight to bring inflation down, the Fed has "...covered a lot of ground, and the full effects of our rapid tightening so far are yet to be felt. Even so, we have more work to do. Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy." Inflation over the next year will depend critically on the credibility of that statement.

As a sidenote, the Sticky Price CPI index doesn't look very sticky. Despite the fact it is meant to measure the prices of good and services that do not change frequently, and excludes food and energy prices, it is only in the recent episode that it lagged appreciably behind the other measures as inflation initially rose. It also has not yet peaked (as of January 2023).  

Role of money at the lower bound

Roberto Billi, Ulf Söderström and I just reviewed the proofs for our forthcoming JMCB paper, "The role of money in monetary policy at the lower bound."  In the paper, we reconsider the merits of strict money growth targeting (MGT) relative to conventional inflation targeting (IT) and to price level targeting (PLT). We evaluate these policies in terms of social welfare through the lens of a new Keynesian model and accounting for a zero lower bound (ZLB) constraint on the nominal interest rate. Although MGT makes monetary policy vulnerable to money demand shocks, MGT contributes to achieving price level stationarity and significantly reduces the incidence and severity of the ZLB relative to both IT and PLT. Furthermore, MGT lessens the need for fiscal expansions to supplement monetary policy in fighting recessions.

While the framework we employ is a stylized, but common, New Keynesian model, our findings suggest a productive avenue for future research will be to explore the re-introduction of money into monetary policy in a wider class of model environments.

Here is a link to the current draft of the paper. The final JMCB version should be available soon.