A Broader View on Inflation: Looking at the Forest, Not the Trees

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Sep 14, 2017 1:14:43 PM

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inflationAmong economists and investors, one of the biggest problems out there is inflation. It should be rising, but it isn’t. Related to this and contributing to the problem is that wages—according to theory and past history—should also be rising. Together, these would push all prices higher but are not. What's going on?

The Phillips curve

The Phillips curve, an empirical observation elevated to the level of an agreed theory, states that inflation and unemployment have an inverse relationship. That is, as one drops, the other increases. When both are dropping at the same time, as they have been, this suggests that we don’t actually understand how the economy works. And that, for the Fed and everyone else, is a big problem.

Much of the commentary has been about the breakdown in this relationship here in the U.S. Indeed, it is both real and concerning. I would suggest, however, that broadening the frame a bit makes the breakdown quite a bit more understandable.

The labor market has changed

When the Phillips curve was first developed, the relationship between U.S. inflation and U.S. unemployment was pretty direct, as the U.S. had little exposure to labor markets outside the country. The U.S. labor market stood on its own, and U.S. inflation was largely driven by it. That started to change in the 1970s, when spikes in oil prices pushed inflation up even as growth slackened in "stagflation.” But the relationship was still there to the point that the “wage-price spiral” became a term of art.

Since then, as you may have noticed, the U.S. labor market has changed. The effective U.S. labor pool now extends far beyond our own borders to Mexico, to China, and now to emerging markets like Vietnam and Ethiopia. As much of the production is indirect rather than direct, that labor pool can also be scaled up or down easily. With a larger and more flexible workforce, U.S. companies are much less bound to U.S. workers. Small wonder then that the connection between unemployment and wage growth in this country has weakened—and with it the connection between U.S. unemployment and inflation.

A weakened connection

Here, looking at the forest, and not the trees, makes sense. Note, though, that the connection has weakened, not disappeared. Many companies don’t have the option of outsourcing labor globally. Others choose not to, for a variety of reasons. Finally, many jobs simply have to stay in the U.S., as they require a physical presence. The U.S. labor supply and market are still important, just less so.

The various components also have different impacts on wage growth and inflation. This differentiation between jobs that require physical presence and those that don’t, coupled with the differentiation between high-skill and low-skill jobs, explains a great deal of how the labor market has changed. This includes the balance between high- and low-skilled job creation here in the U.S. and wage growth. By changing the composition of both existing jobs and job creation, the globalization of the labor market has allowed companies to optimize, from their perspective, how they use labor. This, in turn, has kept wage growth low.

Will wage growth accelerate again?

Because of all of these factors, wage growth has taken much longer than expected to get going. As I discussed in yesterday's post on recent stock market records, however, we are now at a point where there appears to be a real shortage of American workers. At some point soon, wage growth will have to accelerate here, or the Phillips curve really is broken. I don’t think we have evidence of that today. If it does happen, we will know in the next year or two. I suspect that the much more likely outcome is that wage growth will instead accelerate again, as theory suggests.

The relationship between wage growth and inflation has not gone away either. When wage growth does start to accelerate, expect inflation to pick up as well.

Never say never

The idea that inflation is dead is the latest iteration that, somehow, things are different this time. That may be so. Mass automation could be something that really would make it different. But right now? This looks like an understandable reaction to a wider and broader labor force, not a fundamental change. As such, it has taken us longer to get to the point where wages and inflation start to rise. Just remember, longer does not mean never.

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