A simple model of a reluctant Fed

Imagine there is incipient downward pressure on real wages, just as real wages have fallen in Japan and male real wages have been flat or falling in the United States, both across longer-run periods of time.  Yet for the usual reasons of morale and uncertainty, employers do not wish to cut real (or nominal) wages.  An extra three to four percent price inflation would cut real wages by three to four percent for a large segment of the employed.  It would accelerate a trend which is already underway, and will eventually happen anyway, yet it will telescope a lot of that trend into pre-2012.

There are more employed than unemployed, by a considerable margin, plus many of the unemployed do not vote or do not vote strategically.  The inflation may be a Pareto improvement, desired by benevolent central bankers, but why should an office-holding politician desire this outcome?  Which politician wishes to accelerate a decline in real wages?

Most generally, I suspect that electoral opposition to inflation will rise to the extent median wage stagnation is a problem.


As long as the fixed-income retirees vote in disproportionate number (as they always do), inflation fighting will be the Fed's number one job. The whole thing is a giant con game in reality as the Fed has given up (and Congress and the Prez are MIA) on any effort to achieve "full" employment (what ever that would be). In the meantime, a report comes out that the US of A ranks only 23rd (might be a little off) on infrastructure spending. Sure we had a burst with the money the last Congress freed up but anyone who has looked at roads and bridges must worry for the future. A sad commentary in reality particularly when the focus is on cutting spending. The time will come when FEMA won't have any money to help out places that have been struck by natural disasters (witness the destruction by the recent tornadoes).

A lot of entitlement programs are indexed for inflation.

Don't many of the price indexes used exclude energy costs? I would estimate that energy costs make up a large chunk of fixed-income retiree expenditures.

What about the time lag from when price increases are realized in consumer goods to when the entitlements are re-indexed?

I also think your point underestimates the psychological impact of good old days syndrome. When retirees see items cost 5 to 10 times what they paid for them when they were younger they're going to take note and vote accordingly regardless of their incomes increasing.

Social Security is indexed using the full cpi with food and energy.

First of all, "an extra 3--4 % price inflation" is a lot. It impliess that e.g. yearly inflation is up 2 percentage points on average for two years. Furthermore, one reason nominal wages have been flat for a considerable period is dislocation in the labor and goods markets. If inflation were higher, real wages might fall for a while. But real prices for many goods would also fall, which (given the large margins we see in many industries) would lead to expanded output and place a floor on real wages.

Then again, I'm not convinced that the Fed is being unreasonable. Market-based expectations for 10-yr inflation are pretty much on target, and near-term measures are expected to be high as well due to rises in food+energy.

But the Fed doesn't control oil drilling in Saudi Arabia or crop yields, so it's hard to argue that the Fed can do anything about food and energy prices.

Besides, oil is currently in slight backwardation, suggesting that its price is likely to fall soon. The price increase is likely to be temporary, not sustained.

The Fed can't do much about any particular price, but as long as it claims to care about inflation it must take all prices into account, including food and energy.

There is a separate argument that we shouldn't care about food and energy after all, because they're traded on competitive markets (hence they are not demand-constrained) and their prices are flexible. It's a fairly sensible argument, but actually implementing it would require a lot of institutional change. At some point, switching to price-level or NGDP-level targeting would make a lot more sense.

But I thought our politicians have a strong dollar policy and Fed actions are merely asset swaps...they aren't causing inflation.

Ah, I see you made the fatal error of listening to what they say.

All these theories are sketchy...show me some real empirical studies showing that QE is causing the transitory price increases in commodities. Make sure to cite some real peer reviewed studies too...not just crackpot stuff.

"There are more employed than unemployed, by a considerable margin, plus many of the unemployed do not vote or do not vote strategically."

This is presumably why the OASDI (SocSec) tax cut was on the employee's side (benefiting the wages of those with jobs more, to the extent that stickiness exists) rather than the employer's (benefiting the unemployed, mutatis mutandis.)

"An extra three to four percent price inflation would cut real wages by three to four percent for a large segment of the employed."

Why do you assume inflation won't hit wages? I thought monetary induced inflation was all about a wage-price spiral. So now you believe that prices can rise without an increase in demand to explain that price rise? Do explain.

This is a wishy washy post. You have a responsibility to take a stand. Should the fed engage in QE3. I think they should, and I think you should have the courage to take a position on the matter.

Yes. "Free money" is so courageous. Heroic.

I didn't say free money is courageous. I said taking a strong position on the most important issue of the day in the field of your expertise is courageous. Choosing to talk about the political economy instead is a cop out. That said, I think Tyler's post claims that defending QE in the current environment would be courageous. Blasting "free money" (i'm not sure who you were quoting there) is not courageous either.

Depends on what you want? to create a run on commodities via the end of the dollar...then go ahead.

If you want to crash the stock markets and housing markets a quick 50% then end all the QE. At the same time we would see interest rates on the US debt auctions skyrocket so get ready for a deficit expansion to over 2 trillion per year.

I say end the fed and default on the governemnt bonds. It is immoral to stick future generations with the debts of thieves and idiots.

Gabe, I can't tell if you're serious. I assume you are joking about defaulting on our debts. Just in case, I'll point out that squandering the good faith and credit of the US Government and making it impossible for future generations to borrow at competative rates is irresponsible.
Anyways, people can simply look at Ireland or Spain and see what the absence of sufficient QE does to a nation's debts. I'm sure there was some political economy at play there, but what interest me is that excessively tight monetary policy has devastated those economies.
I'll give you the thieves and idiots- no argument there.

"the good faith and credit of the US Government "

LOL. You're killing me pal. The US government WILL default. The Baby Bust won't pay the debt, the immigrants won't pay the debt, so the government will either have to repudiate it or debase the currency.

I'm killing you? Back here in the real world, rates on US debt are at record lows, with low speads and nearly flat yield curves. The simple fact is that it is quite easy for us to borrow. A default would likely change that. Where is the flaw in my reasoning? BTW: What's with the random shot at immigrants?

Rates are low b/c we're successfully importing inflation to finance our private and public deficits; they do not reflect economic reality. Eventually, they will.

It's not a "shot" at immigrants. It's the fact that they're not coming here to pay taxes to finance your debt. Nor will there be enough of them in high tax brackets (those that aren't net tax consumers, which is a substantial number as well).

There hasn't been a decline in real wages.
For Executives.

If this was a case of wages being the problem, then wages of management would decline as well. A firm would seek to minimize those costs at the same time. But, they haven't. Watch the bonus announcements in the newspaper.

This is a case of lack of aggregate demand, not of excessive wages. You can try to lower wages, but it will not lead to higher employment.

But, if you take the contrary view: that if we can just find a way to lower total wage costs, then I suggest we find a way to lower executive compensation.

That will lower total wage cost. Won't it.

That looks like a good reason to have free banking rather than a central bank.

Very, very few voters understand how or why inflation happens, so debtor governments can count on being cut a great deal of slack in pursuing inflationary policies. Also, with a monopoly on nuclear weapons you can pretty much do whatever the hell you want.

The Fed governors aren't elected.

Monetary stimulus lowers real hourly wages and raises real aggregate wages. This is because nominal hourly wages are sticky, but monetary stimulus raises real GDP. Not all the extra real GDP goes into aggregate real wages, indeed profits rise more than proportionally. But wages (broadly defined) are such a large share of GDP that total aggregate real wages are likely to grow in an expanding economy. This is partly more jobs, and partly more hours for each worker.

The political question is; which do voters care more about, hourly real wages, or aggregate real wages? I suspect the latter.

That sounds reasonable, but Tyler believes the unemployed are mostly Zero Marginal Product workers -- so why would firms hire more workers if their marginal product is zero?

The employer isn't sure who is Zero Marginal Product until after a certain amount of time on the job...most everyone is negative marginal product the first day. Good employees become positive marginal product quickly..bad ones may become positive marginal product after a few months and then slack off again...after fooling the employer into thinking they are positive marginal product...2 years later the guy has cost the company lots of money in return for doing almost nothing.

Your oversimplified models are sucky

I'm not the one who believes high unemployment is due to ZMP workers. It's Cowen and Kling who believe that theory.

My theory, as always, is: look at the stock market to see what earnings expectations are. If the level of the stock market is no higher than it was 10 years ago then earnings expectations are no higher than they were 10 years ago and no surprise that the number of employed are no higher than 10 years ago. That's my oversimplified "model".

Zero Marginal Product. Not Zero Absolute Product. If you lower real hourly wages, than presumably some % of those ZMP workers become Positive Marginal Product workers. That's kind of the whole point.

OK, that makes perfect sense. That explains it way better than Tyler did. Tyler has cast suspicion over the whole theory of sticky wages, so I wasn't understanding ZMP workers in the light of sticky wage theory but you have illuminated it for me. Thanks.

If the voter has a significant mortgage payment, nominal wages may be more important than real wages. May people would benefet from nominal wage growth, even if it included a real wage decrease, simply because it makes their mortgage cheaper. Nominal growth also has the potential of moving underwater mortgages into posative equity. Nominal growth accompanied with real wage losses has the potential to help many people that are currently employed. Add to that the potential to reduce unemployment and improve employee bargaining power over time, it should be an easy choice. Of course Tyler seems to be about as brave as Bernanke is.

You might view Stiglitz's critque of that argument and consider that as more plausible and in line with what has happened to date.

His view, to summarize, is that the excess liquidity flowed to developing countries (afterall, this is a world market, isn'it) and that QEII thus far has failed to address the real problem: liquidity and loans to small and medium size entities.

Look at it this way: if you were a large bank, where would you send your excess cash--to some small US enterprise, or to a foreign market where you earned more return.


Where does the foreign market send the dollars it gets?

As a currency of international exchange, the dollar isn't just exchanged for US goods.

Or, maybe you think it is, but a lot of foreign contracts are denominated and resolved in something called a dollar.

But, maybe it doesn't have a face of Washington on it, but rather is an electronic tic on a computer screen.

Am I completely missing something when I suggest the fed could just loan directly to SMEs? Or is the problem there just legal?

(Inflation in capital letters is not a sufficient response)

Cahal, That was one of the points Stiglitz made (it was a discussion between him and a former fed official). I do not know the mechanisms for reaching sme's, but you might want to look for the Stiglitz speach.

The Fed could stop paying interest, or even charge interest on reserves. Then banks would be incented to lend to SMEs.

"The political question is; which do voters care more about, hourly real wages, or aggregate real wages? I suspect the latter."

What universe do you live in? A voter cares about the dollars in HIS wallet, not the wallet of some incorporeal aggregate. "Honey, be sure and punch the ballot for President So-And-So. I'm looking at the BEA reports right now and aggregate wages are UP!"

There's so many problems with a post like this: The conclusion is wishy washy, non-quantitative and hard to test. The trends are incipient and motives are imputed. The fed itself is a complex model that none can make good predictions about anyways. And finally, even if we had a conclusion it is not translatable into any sort of policy or action.

What's the point? Clairvoyance?

I agree with Bill. There is an assumption here that if wages fell in real terms, employers would hire more workers. So if inflation causes wages to fall in real terms, you will reduce unemployment. But there is no reason for the assumption to hold. This downturn appears to be different in many ways, and one of them is that even if companies can afford to expand their workforce, they would rather use the money for just about anything else.

Many on the right argue that median real wages have really been going up, if you include healthcare. If this is true, you can push wages down much more by simply severing the link between employment and healthcare, so employers no longer have to pay the healthcare costs of their employees.


Unfortunately, that would have a lot of other consequences, obviously.

It's not different. We're back in the 1970's.

In the 70's there was a wage-price spiral and housing prices were shooting through the roof. Look at wages and house prices now. They don't look at all like the 70's.

The story now is this: the demand is not domestic. If the demand were domestic people would be buying houses now that they are back to their prices of ten years ago -- but people aren't. There is no domestic demand to turn dollars into hard assets. But China wants to put foreign currency into hard assets, so internationally fungible assets are soaring, gold, silver, etc.

There is still not much demand in the USA. Wages and real estate prices are stagnating. This isn't the 70's at all.

We are in a time of rising prices and stagnant employment, as in the 1970's. Housing is falling, but only because of a rigged boom that took prices to absurd levels.

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