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It’s Alive! Or Is It? Economists Spar on Inflation Frankenstein

  • Inflationists say inflection point in overall prices is near
  • Some measures of employment and wages still show slack

Reminiscent of a scene from the 1931 film classic “Frankenstein,” a cadre of economists and investors are now shouting “It’s alive! It’s alive!” with respect to the long-dormant U.S. inflation monster.

“Labor market overheating,” Torsten Slok, the chief international economist at Deutsche Bank AG, headlined an email note after the January jobs report showed a 2.9 percent year-over-year jump in average hourly earnings, the largest since mid-2009. Paul Tudor Jones, the hedge fund manager, warned in a Feb. 2 letter to clients that inflation was going to return “with a vengeance.”

As markets calm after a roller-coaster start to the week, the question bears asking: Has the U.S. finally reached the long-missing inflection point where labor markets are so tight that wages begin to rise and companies begin to pass along higher costs? Economists looking at the same evidence are taking opposing views.

“It’s absolutely, bloody astonishing” that anybody would reach such a conclusion if they looked at the data, said Danny Blanchflower, an economics professor at Dartmouth College in New Hampshire. “Inflation is not going to take off.”

Just how this debate plays out matters to every worker and every job seeker as much as it does to bond traders. U.S. central bankers estimated in December that the economy is fully using labor resources with an unemployment rate in a range of 4.3 percent to 5 percent. 

What Our Economists Say

Labor costs are the dominant input cost in almost every industry, so labor scarcity will drive up prices eventually -- and we are approaching that threshold with the unemployment rate due to slip below 4 percent  this year. The laws of supply and demand have not been repealed, and they very much apply to labor.

-- Carl Riccadonna and Yelena Shulyatyeva, Bloomberg Economics

But even with the jobless rate currently at an almost 17-year low of 4.1 percent, officials still projected that the low-inflation environment that’s persisted for the past five years would allow them to adhere to a strategy of gradual increases in interest rates. If they conclude they’re wrong, Blanchflower said, their goal will be to cool off growth and probably raise unemployment.

The sides in this debate break down into those who put more weight on a forecast of a non-linear jump in wages and prices versus those who say current price trends say a lot about future trends.

What does the evidence say?

Something is gradually changing. Both service and manufacturing companies surveyed by the Institute for Supply Management have reported an upswing in prices paid to suppliers for the past few months.

The government’s employment cost index, which measures both wages and benefits, is also trending higher.

Whether these trends translate into higher prices for consumers depends a lot on how companies behave. There is little evidence that companies have confidence in their ability to pass along higher labor and supply costs to customers and consumers right now. A measure of year-ahead business inflation expectations in the Atlanta Fed’s district has been bouncing around 2 percent for the past year.

When labor gets more expensive, companies typically seek ways to find substitutes in technology or cheaper off-shore labor pools.

Kevin Hassett, the chairman of the White House Council of Economic Advisers, said in an interview that the tax reform package passed in December was well-timed to this stage of the labor market. The new law allows companies to fully expense new investments for five years. If workers have better capital to work with, that could boost productivity and raise pay without inflation.

Fed Projections

The CEA’s simulations of the tax package’s effect on inflation don’t deviate from the Fed’s own estimates, Hassett said. “There is nothing in the simulations that suggests the Fed’s forward guidance is incorrect.”

The median forecast published by Fed officials in December was for 1.9 percent inflation this year and 2 percent next year.

Joel Prakken, chief U.S. economist at Macroeconomic Advisers by IHS Markit, countered Hassett’s view that higher productivity will quickly offset the inflation impact of the legislation’s demand boost. It’s “unlikely that the capital inputs will displace labor inputs so quickly,” Prakken said.

His firm predicts a modest overshoot of inflation in 2019 as labor markets tighten further. “We are hardly inflation alarmists,” Prakken said.

Finally, there is the messy question of just how much slack there is in the labor market. Blanchflower, a former Bank of England policy maker, points out that the U.S. employment-to-population ratio, a measure of what percent of the working-age population has a job, is 60.1 percent, below the 62.7 percent average that prevailed in the last expansion. 

Another measure of compensation -- gains in average hourly earnings for production and non-supervisory workers -- is flat-lining, as it has for much of the expansion, he notes.

“You have no sustaining wage inflation,” he said. “You are probably many millions of people from full employment.”

Slok, however, said that the employment cost index and anecdotal data all point to an economy at full employment. In the Fed’s most recent Beige Book economic report published Jan. 17, the word “shortage” is used 20 times in reference to the labor market.

“Why have interest rates gone up for the last three or four months?” asked Slok. “I think it is pretty obvious -- the inflation data has been signaling that something is coming.”

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