Do tight labor markets cause inflation?

From John Cochrane:

That paragraph contains a classic economic fallacy, that of composition; the confusion of relative prices and the level of prices and wages overall. If labor markets get “tight,” companies finding it hard to find workers, then yes, one expects wages to rise. But one expects wages to rise relative to prices. You only tempt workers to move to your company by offering them wages that allow them to buy more. Similarly, if there is strong demand for a company’s products, its prices will rise. But those prices rise relative to other prices and to wages. Offering a company higher prices when its wages, costs, and competitor’s prices are all rising does nothing to get it to produce more.

So, in fact, standard economics makes no prediction at all about the relationship between inflation — the level of prices and wages overall; or (better) the value of money — and the tightness or slackness of product and labor markets! The fabled Phillips curve started as a purely empirical observation, with no theory.

To get there, you need some mechanism to fool people — for workers to see their wage rise, but not realize that other wages and prices are also rising; for companies to see their prices rise, but not realize that wages, costs, and competitors’ prices are also rising. You need some mechanism to convert a rise in all prices and wages to a false perception that everyone’s relative prices and wages are rising. There are lots of these mechanisms, and that’s what economic theory of the Phillips curve is all about. The point today: it is not nearly as obvious as newspaper accounts point out. And if central bankers are a bit befuddled by the utter disappearance of the Phillips curve — no discernible relationship, or actually now a relationship of the wrong sign, between inflation and unemployment, well, have a little mercy. Inflation is hard.

There is more at the link.


Are any companies fooling anyone in this manner? Bay area companies are attracting plenty of workers with high wages to an area with an even higher cost of living. If Amazon places its second HQ in an Alabama or Idaho with very low costs of living will people flock?

I tend to see it as being fooled, but they would argue it's really worth it to live there. I think for a lot of them they are being fooled, pursuing very highly paid jobs for the social-status/psychological reason of being able to say they make that much money, discounting the amount they have to spend for housing or seeing it as another status symbol. But many others in the tech industry want to live somewhere affordable. Amazon will be placing its second HQ in Denver* and I'm sure cost of living for the workers was a consideration. Yes, many people will flock.

*I'm 98% sure of this due to inside information, no, I don't expect you to believe me.

I am no economist, but I still suspect that the Phillips curve has been killed by cheaper and more widespread knowledge, and the usual counter cyclical effect of a efficient market. As always, transaction costs are lower, and shibboleths (like the curve) are shorter-living.

Kind of like the "January Effect" in stocks: once it was published, the effect went away.

If Milton Friedman is one extreme (inflation always monetary) and Fischer Black another (inflation never monetary or not even logically such), where do you stand between them? Would appreciate/enjoy some degree of elaboration, or alternatively, why is the question dumb and reflective of massive ignorance?

High inflation always monetary (except in cases like the US financial crisis where M was increased a lot, but much of that was not loaned out by banks).

I don't see the necessity of "fooling". If I need a worker and I can only get him by offering a loan above current market price, I will do that, even if I am aware this will start a inflation cycle. The same goes for the worker, I suppose. Etc.

If the quantity of money remains the same, your paying more for a worker will imply less money to buy something else, and the price of that will decrease. No inflation.

Assuming velocity does not change.

When the facts (empirical observations) no longer fit the theory (Phillips curve) it is always cause for concern.

Cochrane: "You only tempt workers to move to your company by offering them wages that allow them to buy more." Of course, that's a fallacy. If one's current employer doesn't offer wages that allow one to buy at least the same goods even if not more, one is tempted to move to another company that at least allows one not to lose ground. American workers have become fearful of losing their jobs and losing more than ground (I call it fear while Cowen calls it "complacent") and don't move from place to place or employer to employer. Media may complain that averages real wages have been stagnant, but real workers are happy just to be stagnant and not lose their jobs or ground. Back in the good old days, when manufacturing jobs were plentiful and the gap between wages paid to the rank and file and the wages paid to the top executives wasn't all that great, companies spread the their good fortune among all who contributed to the good fortune. Today, with service jobs replacing manufacturing jobs and the gap between the wages paid to the rank and file and the wages paid to the top executives is great, companies don't spread their good fortune among all who contributed to the good fortune. Just consider health care, the fastest growing sector, where the top executives (physicians, hospital executives, etc.) are paid far higher wages than the supporting personnel; or banking, where the top bankers are paid wages that are so far higher than the wages paid to the rank and file the gap is as wide as the distance between Wall Street and Mars. When Cochrane et al. complain that "inflation" is much higher than official records indicate, they are correct, because rising asset prices have replaced rising wages as their barometer, and it's rising asset prices that reflect the good fortune of the most fortunate.

FYI, as usual, Scott Sumner provides the most coherent explanations of all things monetary:

In a recent conversation with a credit union employee I asked how she saw the state of the economy. She replied that things were looking good. More people were applying for loans. Ergo, in consumer world, when unemployment is low and economic activity high, people don't save money but instead borrow it.

Sample bias there.

Why are people going to a credit union employee? They are either setting up an account or applying for a loan. Most people don't deposit their paychecks directly in person anymore. So possibly her only insight into the economy is looking at loan applications and maybe a surge in new accounts. Perhaps if the credit union has small retail businesses they might come in with cash deposits which could indicate how well business is doing but even then a lot of transactions happen by card and larger stores use an armored car service to deal with cash. It's also locally biased, the economy could be going to shit but if there's a fraking boom in your town they might be doing great.

Still it is a measure, people borrowing money indicates they feel confident they can pay it back...

@BC - Sumner's column is typical gibberish. (1) assumes sticky wages (not necessarily true, and for purposes of inflation rather than unemployment not even relevant, since you can replace a worker with a machine), (2) "The same is true of the Phillips curve. It worked OK for many years, especially under the gold standard" - makes no sense, since the Philips curve was a creature of the 1960s, while the gold standard died in the early 1930s, and (3) contradicts himself with this passage: "Japan can’t create inflation? Really? What if they devalued the yen from 112 to the dollar to 600 to the dollar? No inflation? Then what about 6000 yen to the dollar? Inflation is always and everywhere a money supply and demand phenomenon." - you will note Sumner implicitly agrees that inflation might *not* increase if you devalued the yen from 112 to the dollar to 600 to the dollar; that speaks volumes that inflation is not, except in the extreme of hyperinflation, 'a monetary phenomena'.

Inflation is hard? Let's consult with Boy Genius Bobby Mugabe, he can divine the secrets of inflation.

Right! You got to inflate like you really mean it--using scientific notation!

Has Cochrane looked at the "expectations-augmented Phillips curve" lately?

What is that? Explain it in English. Is it nothing more than metaphysics, backwards looking in that it predicts: "inflation exists only when people think it will exist, and the proof is in the pudding"? If so, it's nothing more than fancy metaphysics and backwards looking curve fitting, that proves nothing. Crystal ball gazing is more accurate.

No Ray. Once people started to anticipate inflation in the 1970s, the Phillips curve fell apart. Remember double digit inflation & double digit unemployment?

Do changes in supply and demand cause inflation?

Yes. What Cochrane is trying to explain however is that the Philips curve is not accurate. It's a bit of a strawman since empirically the PC died about forty years ago.

Question for the audience: is getting your hands on the latest smart phone from the trendiest company, or the hottest toy of the season, inflation? Or getting what you want? Extra points if you mention "Veblin Goods".

Bonus trivia: Cochrane was an outrageous British sea captain of the early 19th century; won numerous battles in South America on behalf of countries there using an inferior ship as well as in Greece during their war of liberation vs the Turks.

"So, in fact, standard economics makes no prediction at all about the relationship between inflation — the level of prices and wages overall; or (better) the value of money — and the tightness or slackness of product and labor markets!"

Let's think this out a bit. Imagine an economy that has even inflation for a very long period of time. Say 50 years straight of 5% inflation. In such an economy it is probably very difficult to figure out what actually increases first, wages or prices. Since it is so regular everything might just change by 5% every January 1st.

But during the year you are going to get prices and wages bouncing around for different individuals and products. Some workers retire, others get promotions to fill in. Some things go in and out of fashion. But if the price of one thing goes up by 10%, say, then that implies the price of something else has to go down or up by less in order for everything to net out to 5% inflation.

But suppose there is unexpected inflation. Initially something is probably going to go up in price first and at first that price increase is likely to be seen just as part of the normal froth of prices going up and down in the economy. Except this time one price goes up but the next thing doesn't go down, it goes up too, as people wait to see what will fall to make everything even out to 5% inflation Every time something goes up more than expected, the number of products that might go down in price to compensate becomes less. The odds that this is just your normal 5% inflation start going down until they drop to zero and then the entire economy realizes this year it will not be 5% inflation but something else.

Let's forget about a model where people in the economy are trying to do macroeconomic modelling. Instead they look at past inflation and they look at the prices of things they buy regularly often and the prices of other things less often. A shift in prices they see might simply be random change or might signal a change in overall prices. They could start looking at more prices but that has a cost (time, energy, etc.) If an agent thinks a price change is happening overall, their behavior will change but if they think they are just seeing random price changes as part of their basket of goods and services, their behavior will just change in terms of allocation. In other words, if the price of salt goes up 5%, a consumer might buy more pepper as a substitution if they believe this is randomness. On the other hand if they think this is a signal of overall price inflation they may buy more salt. In the first case pepper appears cheaper than salt. In the second case salt today appears cheaper than salt tomorrow.

Now that I laid it out for you, just add math and we'll agree to share the Nobel.

I think you'll have to share it with Hayek.

Lucas on Price expectations and the Phillips Curve

Lucas aggregate supply function on Wikipedia

A test of Lucas's ideas

One study does not prove anything. Other studies have shown that nominal effects have no real effects, e.g. in Fx markets, see the late 1980s work by Alan Stockman and others.

Doesn't it come down to what creates he demand?

If mortgage interest rates rise by 1% the housing prices in the BC market drop by $40k. Except that the marginal price of a home is what a Chinese buyer moving money out of China will pay.

I've seen a doubling in prices of most of my inputs over the last two years. Those price increases are passed along to the customer. The CAD devaluation doesn't add up to that, so where did the increase come from? Prices have been almost flat for a long time, with cost increases swallowed. A substantial price change from the CAD going from roughly $1 USD to .70 starts a movement which ends up in a doubling of prices.

The price increases in my industry are passing on increased costs.

The money created by the Fed has driven up prices in only certain markets and locations, indicating that the gains from these policies haven't been spread widely.

"The money created by the Fed has driven up prices in only certain markets and locations, indicating that the gains from these policies haven’t been spread widely."

One possibility is that you are looking at prices randomly moving around without any real impact from the Fed. The other one doesn't quite make a lot of sense. If your supplier's dramatically increased their prices because the Fed printed more money, then they are now getting more money for doing the same thing they did in the past for less money. If this isn't spreading widely then instead of using that additional money to do something...anything from building bigger plants to just throwing extra fancy office Christmas parties then it would have to start spreading.

This begs the question why were they able to just say "you have to pay more for the same stuff" now? What was preventing them from doing that before? They were nice guys? Unlikely. Did competition disappear? Are they getting orders from the rest of the world?

The lack of inflation can be easily explained by the Global Slack Hypothesis.

Basically what matters in a globalized economy is the level of global slack, not domestic slack.

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