Goldman Picks a Side in One of the Fed's Most Contentious Debates

Getting to the bottom of inflation's chicken-or-egg problem.

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Federal Reserve officials who believe a tightening labor market is sufficient proof that inflation is on the way up have a friend in Goldman Sachs Group Inc.

With monetary policy makers beginning to rethink conventional wisdom on how inflationary pressures build, Goldman's U.S. Economist Daan Struyven offers some evidence that may tip the scales towards raising rates sooner rather than later.

In a research note on Tuesday, Struyven seeks to answer inflation's chicken-and-egg conundrum: when the price of french fries rises, does Joe Sixpack demand higher wages from his employer so he can afford the same amount? Or does the price rise because Joe and all his friends got a raise, and are willing to spend more money to get the same amount of the foodstuff in question? Simply put, does inflation lead, or lag, wage growth?

Using a model that strips away outliers, Struyven finds evidence that rising U.S. wages have preceded an uptick in core inflation since 1974, in stark contrast to the body of academic work which has tended to conclude that price inflation leads wage inflation.

"The implication of our findings is that the observed pick-up in wage growth may be more likely to contribute to the long and winding road to higher core PCE inflation than often believed," the economist writes. "In addition to our expectation that tighter labor and product markets will boost inflation, the fading of any remaining disinflationary effects from oil and the dollar, and the normalization of PCE health care inflation should also move core PCE inflation gradually higher."

Monetary policy makers appear to be divided into two camps: those who have raised the prospect that more progress should have realized on the way to the Fed's 2 percent PCE inflation target before a monetary tightening cycle can begin in earnest, such as Chicago Fed President Charles Evans, and others who believe that the current tightening of the labor market signals inflation is in the pipeline, and monetary policy makers should act now given that rate moves affect the economy with long and variable lags.

Struyven's analysis bolsters the case of the latter camp.

While U.S. wage growth was just 0.1 percent in August, compared with the month earlier, it was 2.4 percent on a year-on-year basis, according to official measures, and 2.6 percent currently, according to Goldman's wage tracker. 

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Deploying something called a Granger causality test, Struyven investigates the relationship between two measures of wage growth — the Goldman Sachs wage tracker, and unit labor costs — against six inflation measures relating to the PCE, and the consumer price index (CPI).

Struyven finds "meaningful evidence" that wage growth:

causes inflation, in contrast to most papers, with 18 statistically significant relationships out of 24 (columns 1-6). Second, we detect less evidence that inflation causes wage growth (with 10/24 significant relationships in columns 7-12). Third, the predictive contents of wage growth and especially inflation appear to have shrunk over time, with fewer significant relationships in the recent 1997-2016 sample.

Goldman Sachs Group Inc

As such, monetary policy makers like Federal Reserve Chair Janet Yellen who continue to profess faith in the predictive powers of the Phillips Curve — which holds that there's an inverse relationship between inflation and the unemployment rate — may be emboldened by Struyven's findings.

This Granger-causality test used by Goldman paints a more robust picture on the wage-price relationship measures compared to many academic studies, Struyven reckons, in part due to the use of a relatively stable wage tracker, which strips out volatile data points. In addition, he suggests that studies concluding that inflation leads wage growth were skewed by energy crises that prompted fuel prices to surge.

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