Academic journal article Economic Perspectives

Do Labor Market Activities Help Predict Inflation?

Academic journal article Economic Perspectives

Do Labor Market Activities Help Predict Inflation?

Article excerpt

Introduction and summary

Price stability is an important element in maintaining a healthy economy. Volatile prices, especially when unanticipated, can have a negative impact on aggregate demand, as people are not able to adjust and protect the real value of their financial wealth. (1) Such uncertainty can result in disruptions in business planning and reductions in capital investment spending, which could be detrimental for the long-run growth potential of the economy. In addition, inflation can impact economic welfare as wealth and income redistributions occur among different agents (Doepke and Schneider, 2006; and Franke, Flaschel, and Proano, 2006).

As experiences of some Latin American countries with hyperinflation have shown, economic growth can be seriously impaired by very high inflation (Heyman and Leijonhufvud, 1995; and Rogers and Wang, 1993). But even at much less severe levels, inflation matters. The U.S. recessions of 1973-1975, 1980, and 1981-82 were all preceded by elevated levels of inflation (Gordon, 1993).

Because of the intrinsic role of price stability in a healthy economy, controlling inflation is a primary objective of monetary policymakers. Understanding the nature of business cycles and short-run inflation dynamics is essential for the appropriate conduct of monetary policy (Svensson, 1997; and Clarida, Gall, and Gertler, 2000). In order to control inflation effectively, policymakers need to identify key indicators that help to predict inflation. Among these factors, labor market activities and, in particular, wages are closely watched. Indeed, since Phillips' (1958) paper demonstrated that there is an inverse relationship between the rate of change in money wages and the rate of unemployment, the relevance of the labor market and, in particular, the link between wages and prices have been taken as given, as noted in Fosu and Huq (1988).

It is unclear whether wage inflation causes price inflation or vice versa. If rising demand for goods and services reduces unemployment (causing it to fall below some natural rate), inflationary pressures might develop as firms bid against each other for labor and as workers feel more confident in pressing for higher wages. Then higher wages could lead to still higher prices. (In an extreme case, this might lead to a wage-price spiral, which we saw in the United States during the 1970s [Perry, 1978]).

However, if rising demand for goods and services (for example, too much money chasing too few goods) induces firms to raise their prices, these price increases and greater profits could entice workers to demand higher wages. In such an environment, inflation could lead to wage growth (Friedman, 1956; Cagan, 1972; and Barth and Bennett, 1975).

If productivity growth drives higher wages, the firm does not have to pass on higher wages into higher prices. Increased productivity therefore should curb inflationary pressures. (2)

A large body of research has aimed to model the inflation process empirically. However, as a recent review indicates, there is no consensus view of the best explanation for inflation (Rudd and Whelan, 2005). The literature focusing on how the labor and product markets interact has also produced mixed results. Much of the evidence suggests that wage growth, even adjusted for productivity, is not a causal factor in determining price inflation. However, inflation does help predict wages (Mehra, 1991, 1993, and 2000; Huh and Trehan, 1995; Emery and Chang, 1996; Hess, 1999; and Campbell and Rissman, 1994).

In this article, we revisit this question by conducting an empirical analysis of the role of labor market activities in inflation, including an examination of the relationship between productivity-adjusted labor costs (unit labor costs), unemployment, and price inflation. We contribute to the body of existing evidence with our use of updated and more recent data, including data for the past ten years. …

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