The passthrough of labor costs to price inflation

Ekaterina V. Peneva and Jeremy B. Rudd have a new paper with the Fed (pdf):

We use a time-varying parameter/stochastic volatility VAR framework to assess how the passthrough of labor costs to price inflation has evolved over time in U.S. data. We find little evidence that changes in labor costs have had a material effect on price inflation in recent years, even for compensation measures where some degree of passthrough to prices still appears to be present. Our results cast doubt on explanations of recent inflation behavior that appeal to such mechanisms as downward nominal wage rigidity or a differential contribution of long-term and short-term unemployed workers to wage and price pressures.

Economists knew or figured that to be the case a while ago, I am glad to see it being relearned.

This research has gone round the blogosphere over the last few days. Above is a link with some explanation.

I suppose this new study undermines both sides of the economic divide; a pox on both their houses! And it seems to confirm the third "side", the monetarists' side, that straddles the fence. One thing all three sides share is fear of wage increases; I suffer, therefore I am. But if wage increases don't drive inflation, isn't this a hallelujah moment for all three sides to rejoice? Or is suffering so ingrained that good news is bad news?

> "But if wage increases don’t drive inflation, isn’t this a hallelujah moment for all three sides to rejoice?"

Well, no. Inflation still remains the major ever present threat; nothing has been remedied whatsoever by yet more noise in the endless river of economic "studies". The authors here are very timid and inconclusive about their own "results". Does not inspire confidence or joy.

The breathtaking ignorance of mainstream economists as to its manifest cause of inflation is a separate psychological issue.

How would an increase in labor costs lead to price inflation? Would the greater costs drive up prices of products to maintain profitability? Businesses that incur higher labor costs are at a competitive disadvantage and must find ways to increase productivity. Or would the larger incomes of workers encourage consumption allowing producers to raise prices in the face of increased demand? If the latter is the case, why wouldn't rising stock prices also be inflationary? Investors that sell stock at a profit have more money for consumption purposes, isn't that exactly the same situation as workers having more money?

@chuck martel - "How would an increase in labor costs lead to price inflation?" -you just gave away your age, you were born after the 1970s. Ah youth.

So in the 70's were rising wages the driver of inflation or the result of inflation, ie. The same wage paid in devalued dollars? It wasn't wage and price controls that tamed inflation, it was a revised Fed policy.

Never reason from a price change.

Isn't the important metric not wage rates but total payroll? If the above study was measuring total payroll in an industry graphed against the total sales and price per unit, what would the result look like?

The problem with research like this is that it assumes there is only one answer to rising wages. Changes in wages will rebalance every part of the economy and every business will respond differently. Some will raise prices, some will invest in productivity improvements, some will work employees more or less hours to minimize employee costs, some will have increased sales that make up for the difference, some will go out of business, some will reduce waste, and some will move operations to lower cost areas. With these different responses any single effect will show little change compared to the initial stimulus especially since the adjustments come slowly over time. But in aggregate they will have an effect and ten years from now people will be asking "why is economic growth so slow?" No one will be able to point to a single cause, whenever a cause is mentioned others will point to the research and say it shows this regulation or this law would have minimal or no effect. So we'll all just throw up our arms and curse the gods and our "bad luck."

Excellent post!

If the wage increase is accompanied by higher productivity obviously the costs are negated in the long run. Productivity is major problem in government. That's why taxes keep going up. All those do nothing patronage workers have a cost as do unions.

The Fed will keep a monetary noose around the economy's neck. One more study....

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