You won’t believe the shocking truth about wages and inflation – it’s not what you’ve been told!

Good morning. Wednesday I look at to the results of discount retailers and wrote that it is “increasingly clear that low-income consumers are under pressure and changing their consumption habits significantly”. Yesterday, Dollar General, another discounter, reported results that forcefully confirmed this ugly trend. “We continue to see signs of increasing financial pressure on our customers as they seek affordable options, including an increased reliance on [store] brands and items priced at $1 or below,” the CEO told analysts. Shares fell by a fifth. Economic downturns do not run smoothly; they are the sum of an irregular series of unpleasant surprises. Email me: robert.armstrong@ft.com

Arguments for not panicking about the jobs report

This morning’s jobs report is even more anticipated than usual. The reason for this is that investor confidence that interest rates have peaked and will soon fall has been replaced by nagging uncertainties. There is an unpleasant suspicion that rates will stay higher for longer – as the Cassandras of the Federal Reserve have long warned – or, worse, could rise a notch or two.

A recent speech Fed Governor Philip Jefferson signaled to the market that a rate hike is unlikely at this month’s Fed meeting, but later the range of possibilities is wide. Some equivocal recent economic data – a hot job vacancies report, a cool manufacturing ISM survey – have only drawn more attention to the jobs numbers.

If the jobs report is much stronger than the consensus estimate of 195,000 new jobs, there could be some panic in the market. But there are reasons to remain calm: a tight labor market may not contribute as much to inflation as is generally believed.

The labor market is getting so much attention in part because Fed Chairman Jay Powell told everyone to watch it closely. At a press conference last November, he divided core inflation into three categories: goods, housing services and non-housing services (NHS). The first two should fall over time, he said, but

basic services other than housing. . . may be the most important category for understanding the future course of underlying inflation. Since salaries represent the largest cost of providing these services, the labor market holds the key to understanding inflation in this category.

“The key to understanding inflation”! Youhoo! Since then, as Omair Sharif of Inflation Insights pointed out to me yesterday, Powell has attempted to backtrack on that comment somewhat. Nonetheless, it’s common to see the Fed’s inflation challenge portrayed as, essentially, the challenge of cooling the labor market.

But two economic luminaries — Ben Bernanke and Olivier Blanchard — have just published a paper in which they argue that the labor market has not been a major contributor to recent inflation. The paper revolves around the argument, earlier in the pandemic era, between inflation optimists and pessimists. Optimists, including Fed leadership, believed that strong fiscal stimulus would not trigger inflation because the Phillips curve flattened (i.e. inflation became less sensitive to the level of employment) and because inflation expectations had been so low for so long. The pessimists, including Blanchard, argued that

[The] the increase in aggregate demand likely to result from fiscal transfers of an unprecedented scale, as well as the cumulative effects of the easing of monetary policy initiated in March 2020, could cause a more significant overheating of a labor market already tense than optimists expected. Extremely low unemployment could in turn cause the Phillips curve to steepen. Moreover, higher and, therefore, more psychologically salient levels of inflation could lead to an unanchoring of inflation expectations, increasing the potential for a wage-price spiral.

While the pessimists were right about the sharp rise in inflation, they were wrong about the role of the labor market, according to Bernanke and Blanchard. Using a “minimalist” economic model, they find that “both the Fed and its critics have underestimated the inflationary potential of developments in the goods markets”, and that “this tension in the labor market has at most contributed modestly to early inflation.

My colleague Martin Sandbu argued yesterday that the Bernanke/Blanchard analysis supports the “team transitory” view of inflation. From this perspective, inflation has been caused by a series of bad supply shocks that ripple through various sectors of the economy. If so, the correct policy response is to step back and let this process unfold on its own, rather than continuing to tighten policy (Bernanke and Blanchard themselves are more hawkish).

The Bernanke/Blanchard model may be “bare bones”, but it’s not easy for a non-economist like me to follow the details. Fortunately, the San Francisco Fed’s Adam Shapiro published an article arguing for the same conclusion with a simpler argument.

First, Shapiro tracks the impact of surprise wage increases (measured by the employment cost index) on core inflation (measured by the personal consumption expenditure index), while controlling for other variables. In particular, it examines NHS inflation, where wages are the largest cost component. What he finds is that

The impact of the ECI on NHS inflation is statistically significant, but its magnitude is quite small. A 1 pp increase in the ECI increases the contribution of NHS inflation to core PCE inflation by 0.15 percentage points over four years, an effect of 0.04 pp per year. As ECI growth has increased by around 3pp from its pre-pandemic level, this means that labor costs have added around 0.1pp to core PCE inflation. current.

It’s not a lot! Next, Shapiro examines the different effects of wage increases on supply- and demand-induced inflation. It distinguishes between the two types of inflation by looking at movements in unit prices and volumes. With supply-driven inflation, prices go up but volumes go down (there is less to sell, so the price of each unit goes up); with demand-driven inflation, the two move together (suppliers raise prices And sell more stuff to greedy customers). He finds that surprise ECI wage increases have no impact on demand-driven inflation, suggesting that “firms tend to raise prices when wages rise because their costs are rising, not because the demand increases”.

Sharif of Inflation Insights makes much the same point without any economic model: he just takes a close look at NHS inflation data.

It notes that around two-thirds of the sharp rise in NHS inflation in 2021-22 from the pre-pandemic baseline was due to transport services, a category that includes air fares, car insurance and auto repair. To what extent was the increase in transport services inflation driven, in turn, by wage increases? Not much, thinks Sharif.

He cites the example of the airline industry. Considering the total increase in industry quarterly operating costs between the second quarters of 2021 and 2022 (as reported by the Bureau of Transportation Statistics), the increase in labor costs accounted for less than a fifth of the change. Fuel was the main culprit, followed by items such as maintenance, food for passengers, advertising and insurance (“transport related” and “other” expenses in the table below):

All of this suggests that we shouldn’t be too obsessed with the tightening labor market – or at least less obsessed with it than we have been over the past two years. Of course, accepting this, we still need to think carefully about what is causing inflation and what is likely to happen next. But that’s another debate. For now, don’t worry about today’s employment report.

A good read

The invasion of Ukraine does not cost Russia dearly moneyUnfortunately.