Inflationary Expectations and Wage-Price Spirals

I think raising interest rates to combat inflation is unnecessary, the increase in prices behind the run-up in inflation is largely driven by real rather than monetary factors, and once the adjustment in relative prices has stabilized at a point that balances global commodity demands and supplies, and once the adjustments have passed through the system, prices will stabilize. In addition, at this point, there are no signs of a wage-price spiral. But I also think cutting interest rates (e.g.) would be a mistake as this would risk creating inflationary expectations that become self-fulfilling, i.e. it would potentially undermine the Fed's inflation fighting credentials and risk generating the wage-price inflation spiral we wish to avoid:

Why those ‘expectations’ matter, by Samuel Brittan, Commentary, Financial Times: The words “inflationary expectations” must by now be familiar to every newspaper reader... Yet a few years ago they were unknown outside specialist circles. ...

They appeared in academic debate as early as the 1970s and 1980s in relation to the so-called monetarist controversy. The key contention of the monetarists was not about the need for money supply targets, as technocrats assumed, but that monetary policy rather than direct intervention in wage or price setting was the right method of tackling inflation. Their opponents believed that this could only work by creating a slump in which millions would lose their jobs. The more thoughtful monetarists did not deny that there was a transitional cost in squeezing inflation out of the system. But the severity of that cost would depend on how credible the policy was. If the main economic actors believed that policymakers would stick to their guns, they would base their actions on the assumption of modest inflation and would frame their behaviour accordingly and settle for moderate increases in pay and prices. If on the other hand they expected the policy to be eventually abandoned, any monetary squeeze would indeed have its main effect in reduced output and employment.

These contentions have been the basis of policy in many countries, at least for the past decade and a half. ... Higher prices for energy, food and imports are pushing consumer price index inflation well above ... target and will continue to do so well into 2009 and thus exert a downward pressure on living standards and real wages. Yet “these increases in commodity prices cannot by themselves increase sustained inflation unless other prices begin to rise at a faster rate. And it is the task of the monetary policy committee to ensure that they do not.” If it succeeds, the reduction in living standards will be a one-off affair... What is surprising is not that inflationary expectations have increased after recent shocks, but that they have increased so little, especially for the medium term. ...

Comments

[Jodie]

How convenient. The FED doesn't need to make any hard choices. The PBOC gets rewarded. And the world moves forward with nothing to lose.

[Ronald Rutherford]

Dr. Thoma, a friend of mine told me about your site and have enjoyed your lectures on Economics 421 - Econometrics, and have finished your 6 lecture so far. While this is mostly review from my graduate class in Econometrics I, it helped fill in some more details that I missed from having distance learning courses.

The question I have today is that while I agree with your assessment of interest rates set by the Fed, I wonder if you have further insights into the nominal levels and what is optimal setting now. It seems that you agree the rates should remain constant but on what basis do you think that is correct, or are you thinking of just the range seems about appropriate? Since it could be considered a negative real interest rate, do you think that may be concern for "priming the pump" too much?

Anyway, I enjoy your blog...

[JKH]

I agree with Mark Thoma's comment. The fact that real wages are declining (per Reich's comment) is not a reason to lower rates (yet); but it is a critical factor in the wise decision not to increase rates in the face of (temporary) relative price increases now showing up in CPI.

says...

And you say: "would potentially undermine the Fed's inflation fighting credentials". Real interest rates are negative so what credentials are you talking about? This is why I think economist belong to the useless profession. They create no real wealth and all they do is stick to their theories regardless of the facts on the ground.

[paine]

puting aside the spectral hocus pocus of expectations
i like this narrative fragment

" The key contention of the monetarists was not about the need for money supply targets, as technocrats assumed, but that monetary policy rather than direct intervention in wage or price setting was the right method of tackling inflation."

this was the path wrong taken by us

the answer known to us marxicocals
as
gross tuning
of the reserve army of the unemployed

leads to dismal sub optimal ...secular as well as cyclical performance

lerner noted this in the 1940's

the problem could have been solved with
a mark up market for galbraith's admin price sector

why verboten ??

well the system would sharpen the class struggle folks
the profiteers could neither flee the field of battle by raising prices
or get rescued by a credit crunch induced job market crash leading to a protracted low grade
chronic under employment system backed by sky hook notions
like fragile expectations momentum
or repackaged dismal science
thru the niaru nuts

the great reagan era taming
of the wage struggle
gets blob ed up
together
with off shoring claims

on the trade gap we can lay the de industrialization

but its on the post 70's macro policy trends we can
lay the crime of gross tuning the reserve army
the alibi for this zoo-do macro
wage price spirals
but its hidden agenda its grinch hearted soul
insure proper big corporation profit margins

" Their opponents believed that this could only work by creating a slump in which millions would lose their jobs. The more thoughtful monetarists did not deny that there was a transitional cost in squeezing inflation out of the system."

and a perminent limp along wage structure to boot

[paine]

i suspect beyond symbolics
the policy rate is about bank lending margins

they astards would like to lower the rate to increase the banks "earnings"
but they've jibbered so much about sending
wrong messages thru that rate drop
out into the market place
where price setting committees of corporate america
will go into mark up overdrive ...

dubiously snared by their own persiflage

hence the "wow are expectations inert or what "
chatter

a way to open the door to another
--if necessary --
rate el dropo ????

[paine]

anon

"Real interest rates are negative"

as well they damn well oughta be

got a bond portfolio ????

[paine]

this obscene notion
that rentiers are
not only entitled to a positive real return
but more importantly
growth requires it

is total bunk
profits of enterprise are the part of social
producer surplus we incentize
our agents thru

by a large negative rate of real interest
thru inflation
to make
"entrepreneurs "do it now
that much more attractive
is pure good sense
in a time of slumping productive investment

[gordon]

Prof. Thoma: "...the increase in prices behind the run-up in inflation is largely driven by real rather than monetary factors, and once the adjustment in relative prices has stabilized at a point that balances global commodity demands and supplies, and once the adjustments have passed through the system, prices will stabilize".

The implication being that inflation is a product of rising commodity prices. Well, John Williams' Shadow Govt. Statistics site now shows US CPI inflation at between 12 and 14 per cent. I have some trouble believing that just represents supply-and-demand for commodities and has no monetary component.

[paine]

gorgon's link yields gemstone passage:

"In particular, changes made in CPI methodology during the Clinton Administration understated inflation significantly, and, through a cumulative effect with earlier changes that began in the late-Carter and early Reagan Administrations...."

wait for it you old bastards...

"... reduced current social security payments by roughly..."

keep waitin'

" half ..."

half !!!!!

"....from where they would have been otherwise"

that's right you rubes ...half !!!!!

" .. Social Security checks today
would be about double
had the various changes not been made"

can you live with it ?????

boy oh boy those pointy headed bastards
whoopin and fudgin' it up
along the potomac
really ..by jingo - ed us ...eh ???

[bakho]

The "weak dollar policy" is in effect to grow exports which has worked. Of course it makes imports more expensive which adds to inflation, but it also brings the trade deficit better into balance. Raising interest rates would strengthen the dollar. Since we owe the rest of the world so much money, it is better for us that we pay them off in weak dollars than in strong dollars.

A rousing round of wage/price inflation would help adjust the falling housing prices. Being worth less in inflated dollars would stabilize price and make them more affordable and fewer people underwater. However, wages are deflating, which only makes the housing problem worse.

[gc]

I wanted Bernanke to stop raising rates, but he took three steps anyway. I wanted more temperate reductions, and he should have stopped between 3.5 and 3. But paraphrasing, you go foward with the rates that you have, not the rates that you want. So, where do my wants get me? Nowhere.

Your desire for rates to stay at 2 seems most important to house prices--let us slow up the price adjustment any way we can, just because people are involved and they need some time to adjust. Higher interest rates will force prices down farther and faster. So let us pull the bandaid off slowly.

But, the inflation was already there, it is in plain sight in the unsupportable high prices in hot areas like California and Fla, and lots of those long term property holders still sit on huge capital gains in comparison to the flyover state residents whose property values never skyrocketed. Just because the recent purchasers are at great risk of being underwater, they are not the whole picture.

[Julio]

"In particular, changes made in CPI methodology during the Clinton Administration understated inflation significantly, and, through a cumulative effect with earlier changes that began in the late-Carter and early Reagan Administrations...."

I don't have enough knowledge to judge this claim, but it confirms one part of my thinking about SS:

The whole idea of its "long term" projections, trust funds, "solvency", and the like is nonsense.

There is a promise that each generation will pay taxes (SS or income or...) and take care of the previous one,
And there is ... nothing else.

If we rely on a "trust fund" as a way of forcing the next generation to make good on this promise, well... if they really want to welch, they have som many ways to do it (eroding the benefits through inflation and fudging the inflation measure being just one of them) that nothing will save us old geezers from the ice floe.

The idea that our generation can "prepay" our retirement by agreeing to a regressive tax increase is preposterous. But it follows rather logically from the (pernicious) idea of having a "long-term" trust fund.

OK, I've said my piece, now let me get out of the way, I think that's Bruce Webb driving a truck in my direction.

[Bruce Wilder]

bakho: "Since we owe the rest of the world so much money, it is better for us that we pay them off in weak dollars than in strong dollars."

No criticism of you, personally, bakho, but I think your comment -- the whole comment, not just what I quote above -- is an excellent example narrative dominating analysis.

By narrative, I mean a dramatic sequence driven by moral values, as opposed to a pure, objective or value-neutral analysis, in which every thing relates to everything, with "cause" and "effect" difficult to isolate.

Why do you imagine that anyone is going to be accept being paid off with "weak dollars"? A "strong dollar" implies that people actually want the dollars (and dollar securities) to have and hold, or to use in international tranactions. I would be concerned that a "weak dollar" will lead to wholesale purchases of American resources, and business assets. That with a weak manufacturing base with which to respond to export demand, instead of selling goods and services for export, a weak dollar will result in selling off real assets. The big banks have to sell themselves to the Arabs to survive; and Ben B. expresses himself delighted. We sold the ports. We sold Budweiser. And, the Indiana Toll Road. There soon won't be enough left of General Motors to sell. If we combine the sale of enough debt with the sale of leading banks and businesses, we can be a banana republic by 2015. wippee!

[reason]

Bruce Wilder
Why do think the US has an alternative? If the dollar is high, you run up your debt (and so run down your net ownership) even faster.

[Flow of Funds]

Total debt to GDP is now about 350%. Since we have no net domestic savings, everything new has to be borrowed from overseas savers, or forced out of inflation vulnerable entities. A balanced flow of funds is impossible under these circumstances.

The strategy of allowing borrowing, and not requiring that full purchasing power be repaid, has created a large mismatch between domestic savings and borrowing.

[reason]

Flow of funds...
Japan did the same thing with different results. I don't think the explaination is sufficient. You can't do this analysis without reference to currency prices.

[Flow of Funds]

Japan had domestic deflation, so domestic savings was encouraged rather than discouraged.

[bakho]

Of course paying off our debt means selling assets in the US. What else would a negative trade deficit require. If our assets are not generating enough export income, then maybe they are overvalued?

While foreign buyers are purchasing American assets, Americans are also purchasing and building assets in foreign countries. It is part of globalization. The excesses of the past decade have cast America as Esau, trading our inheritance for a bowl of stew. Its time to pay the tab.

[Flow of Funds]

"If our assets are not generating enough export income, then maybe they are overvalued?"

Much of the recent borrowing was for consumer purchases, which don't generate any income at all. The plan of many seems to be to just inflate the debt away, and then borrow more to keep on spending. The system treats savers with contempt, and then wonders why savers won't lend any more. Saver psychology seems to be missing from many theories.

During the Depression, savers lost trust because of default so they stored cash in mattresses. Now savers have lost trust due to both inflation and default, so they store inflation hedges. Inflation hedges can't be loaned out any more than stuffed mattresses could. Restoring the trust of domestic savers so they would loan again was an essential part of the original FDR strategy. Little effort is being made to similarly restore the trust of domestic savers today, so they will loan again.

[reason]

Flow of funds - was that a cause or an effect?

[Flow of Funds]

Inflation is always and everywhere a monetary phenomenon. Cause and effect.

National savings requires the trust of savers that they will get back what they loaned out. Several other factors can affect the rate, but trust is necessary. No trust, no savings. Cause and effect.