Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Wage-Price Dynamics: Are They Consistent with Cost Push?

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Wage-Price Dynamics: Are They Consistent with Cost Push?

Article excerpt

For gauging inflationary pressures, many policymakers and financial market analysts pay close attention to the behavior of wages It is widely believed that if wage costs rise faster than productivity, the price level may rise as firms pass forward increased wage costs in the form of higher product prices. Hence changes in productivity-adjusted wages,1 are believed to be a leading indicator of future inflation.

One problem with this popular "cost-push" view of the inflation process is that it does not recognize the influences of Federal Reserve policy and the resulting inflation environment on determining the causal influence of wage growth on inflation. If the Fed follows a non-accommodative monetary policy and keeps inflation low, then firms may not be able to pass along excessive wage gains in the form of higher product prices. In fact, an alternative view is that inflation is a "monetary" phenomenon and is caused by excess aggregate demand. According to this view, the causation runs from inflation to wage growth: firms are able to raise the price of their products because of excess aggregate demand caused by an expansionary monetary policy. The resulting increase in prices leads workers to demand higher wages.

In this article, I investigate whether wage-price dynamics are consistent with the cost-push view of the inflation process. The cost-push view implies that Fed policy and the resulting inflation environment do not matter in determining the ability of firms to pass forward higher wage costs in the form of higher product prices. Higher wage growth should lead to higher future inflation irrespective of what Fed policy has been and whether inflation has been high or low. I test this implication in two ways. First, I investigate whether there exists a long-term equilibrium relation between the price level and the level of wages and, if it exists, whether that equilibrium relation can be interpreted as the long-term price equation, meaning the price level is causally related to wages. The cost-push view implies that the long-term equilibrium relation is in fact the long-term price equation in which wages can be considered exogenous. Then, the estimated coefficient that appears on the wage variable measures the long-term response of the price level to wages. Second, even if a long-term relation between the levels of price and wage series does not exist, short-term changes in them may still be correlated. If the cost-push view is correct, then wage growth should help predict inflation and such predictive content should be invariant to changes in Fed policy and the inflation regime.

I test these implications of the cost-push view using data on the U.S. sample period 1952Q1 to 1999Q2. During this sample period both the nature of monetary policy pursued by the Federal Reserve and the behavior of inflation have varied considerably. In particular, this period contains two subperiods, 1952 to 1965 and 1983 to 1999, during which inflation remained low to moderate and one subperiod, 1966 to 1982, during which inflation steadily accelerated. Furthermore, the descriptive analysis of monetary policy in Goodfriend (1993) and the monetary policy reaction functions estimated more recently in Clarida, Gali, and Gertler (2000) and Mehra (1999) indicate that since 1979 the Fed has concentrated on maintaining low inflation. It is widely believed that as a result of such policy, inflation declined sharply in the early 1980s and has remained low to moderate since then.2 The cost-push view implies that the predictive content of wage growth for future inflation should be stable over this sample period. As in some previous research, these wage-price dynamics are investigated using techniques of cointegration, Granger-causality, and weak exogeneity.

Other studies have previously investigated whether wage growth helps predict inflation. Mehra (1991), Hu and Trehan (1995), and Gordon (1998) report evidence that indicates wage growth has no predictive content for future inflation. …

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