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The wage-price spiral is dead — or at least dormant.
As the Federal Reserve debates when to raise short-term interest rates, this is good news.
Fed Chair Janet Yellen has indicated she'd like to begin the rate increases sometime in 2015, though she says that weak economic data (and presumably the recent stock market turmoil) could cause the Fed to delay. The Fed has held short-term rates near zero since late 2008 in an effort to end the "Great Recession" and strengthen the recovery.
Perhaps more important than when the Fed raises rates is how large the subsequent increases are and how quickly they come. Yellen has said she expects increases to be gradual and modest. Here's where the news on the wage-price spiral matters.
To judge whether inflationary pressures are building, many economists look at trends in wages and fringe benefits. Higher labor costs, it's assumed, are passed on to consumers. So increases in labor costs are considered a reliable precursor of broader inflationary pressures that the Fed should counteract. Otherwise, the economy could fall into a destructive wage-price spiral, as it did in the late 1960s and '70s. (From 1965 to 1980, annual increases in consumer prices jumped from 1.6 percent to 13.5 percent.)
But there's also a downside to squelching an incipient wage-price spiral. It implies that, if the economic recovery continues, workers will have a hard time getting "real" (inflation-adjusted) wage increases, because the Fed will move to slow the economy — and wage gains — before they become widespread.
It all seems logical, if perverse.
But the logic has a big flaw: The connection between higher wages and higher prices has broken down. That's the conclusion of a new study by Fed economists Ekaterina Peneva and Jeremy Rudd. They examined the relationship between increases in labor costs and consumer prices from the 1960s until now. In recent years, there wasn't much. Or to be more precise, the connection was "statistically indistinguishable from zero."
On its face, this seems crazy. Labor costs represent roughly two-thirds of business costs. If they're rising — and aren't offset by improved efficiencies (a.k.a. productivity) — companies must pass them along or go bankrupt. But on a moment's reflection, the change makes sense.
Back in the 1960s and '70s, the wage-price spiral did exist, as the Fed research and previous studies have found. It was not a fairy tale. Wages and prices chased each other upward. Companies could get away with raising prices to match wages because everyone was doing it. In the 1970s, labor costs routinely rose 7 percent to 10 percent a year. They were so large that there was no other way to offset them.
The situation is different today. Inflationary psychology has receded. Indeed, price inflation is running lower than the Fed's target of about 2 percent annually. Competitive pressures restrain wage increases. Although some labor cost increases push up prices, the study concluded that "year-to-year movements in price inflation are likely to mostly reflect a mix of changes" — presumably, raw material costs, the economy's overall level of demand or the specific circumstances of individual industries and localities.
This does not exempt the Fed from worrying about inflation or preventing its resurgence. What we learned (or should have) from the 1960s-'70s experience is that the public hates high and unpredictable inflation. People can't plan for the future; they don't know whether wages will keep up with soaring prices.
Still, the Fed is rescued from the trap that it must stop wage gains before they generate inflation-adjusted increases in living standards. Certainly wages should be one factor that Fed officials follow to warn of rising prices. But the Fed will need to rely more on other indicators.
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