Wages, Expectations, and Prospects for Inflation

Article excerpt

05.27.11

Over the past six months, food and energy prices have risen at an annualized rate of 17 percent, prompting speculation of a possible price-wage spiral that will result in rampant inflation. A wage-price spiral occurs when wage earners start to demand higher nominal wages just to keep up with rising inflation (trying to hold real incomes constant). In turn, these wage increases raise the costs of production, which squeezes margins and induces business owners to raise prices. These even-higher prices then push wage earners to try and negotiate even higher wages, which again prods businesses to raise prices, and so on a resulting in a rapid run-up in inflation.

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For some, this argument may be a nonstarter, given that a wage-price spiral usually requires competitive (or "tight") labor markets. In the absence of a tight labor market, the wage-earner will not hold enough bargaining power to be able to force the firm to acquiesce. With an unemployment rate at 9.0 percent and an employment-to-population ratio that has barely edged up from its current cyclical low, it would be hard to argue that labor markets are anything close to "tight." Nevertheless, we have some data that might help spot this inflationary pressure, should the pace of economic activity quicken and labor market slack dissipate.

As workers and business owners start to see price pressure building, their concern is likely to play into their inflation expectations. Median year-ahead inflation expectations actually edged down to 4.1 percent in May, compared to 4.6 percent in April. The statement that accompanied the data release noted that the downtick was connected to an expectation that gas prices will decrease. Longer-term (5- to 10-year) median inflation expectations held at 2.9 percent in May, remaining near pre-recession levels. Moreover, the latest estimate from the Cleveland Fed's model of inflation expectations suggests that the public expects inflation over the next 10 years to average a relatively low 1. …