Tuesday, 15 October 2013

Targets of Inflation: Nominal Wages

Hard rules have always been a favourite of the economic community. They are easy to use, provide a clear indication of whether policymakers should act or not, and are usually very easy to interpret; that is why there exist so many: Taylor ruleinflation targeting, Evans rule, and so on. Lately, market monetarists have also been advocating NGDP targeting and other hard monetary rules, which as regular readers may remember, did not impress me that much. Lately, I got my hands on a paper by Gregory Mankiw and Ricardo Reis, which promotes the idea of assigning a weight for nominal wages when the Central Bank is targeting inflation for stability.

The main idea behind their modelling is that the Central Bank wishes to minimize the variance of output. Simply put, the less volatile output is, the less inflation we have. After a rigorous mathematical treatment, they reach a very similar conclusion as past paper of  theirs (quelle surprise!), namely that "a central bank should give substantial weight to the growth in nominal wages when monitoring inflation". Yet, there are two things which strike me as odd. First, why should the Central Bank aim at minimizing the variance of output and second, even if their conclusion holds in a boom does it still hold in a downturn?

When it comes to the first question, think of it this way: suppose we have an economy in which output grows by 3% per year, which is what most developed countries aim at and what most have achieved in the past. In year one, output is 100 and in year 10 output is approximately 130.5, with variance over the 10-year period being 105. If one would like minimize variance then the simple answer would be to keep output stable. Yet, although variance would be zero, growth would also be zero. And if population growth is positive then GDP per capital would also fall. What is more, the inflation rate would not really be zero.

In a closed economy, when everything is produced and consumed within the country, controlling for inflation is much easier. Yet, such economies are scarce in the world. Food and energy prices, as Mankiw and Reis correctly note, are determined internationally now with each country's central bank trying to do its best given circumstances created by others. A notable example of inflation from internationally-defined prices is the stagflation experience of the 1970's: oil prices rose by 2.5 times in a year and 15 times in a decade forcing inflation to sore in every developed and oil-dependent country in the world.

But even if, for argument's sake, we accept that the central bank could somehow control for any international discrepancies what happens with growth? Should we sacrifice it for inflation's sake? If population grows and inflation is zero then real rates will rise and we all know what happens when that occurs; it has been evident in both the Great Depression and the European Sovereign Crisis. Deflation is much worse than inflation, especially when citizen welfare is concerned.

Obviously, many will comment, minimizing output variance does not necessarily mean that it will be zero. Yet, what will the target be? We do not know exactly how much output variance makes the inflation rate 2%, 3% or 5%. In addition, what will happen when we have growth, by more than we have expected and it messes up with our estimations? Should we raise rates and freeze money creation or just let it be? The reader may think that I am sliding off subject. Yet, if the starting equations are not correct then one can be sure that the conclusions reached by them are also incorrect. But let's move to the real topic: are nominal wages a good indicator of inflation?

The answer is not really, especially in a recession. Have a look at the next two graphs, obtained from here:
As can be seen, in no country does inflation walk hand-in-hand with nominal wages. The only country which appears to support the notion that nominal wages move with inflation is Spain, albeit whether we can extract a good answer when 3 out of 4 of the countries do not abide by the rule is something quite debatable. Obviously, the CPI is not an excellent measure of inflation; yet whether wages would improve its accuracy is something which I honestly doubt. The only rationale I could accept for including wages in the equation would be that it is just as sticky as prices in a downturn. Yet, this holds more in a recession than in a bubble. When we have growth it is usually prices which rise faster than wages, although the latter manage to catch up eventually.

Mankiw and Reis (page 26) mention that "if nominal wages are falling relative to other prices it indicates a cyclical downturn...". This is exactly what is not happening. Wages are not falling, at least for a long while. In Greece, wages were increasing until early 2010, actually rising more than the CPI. In the next sentence we see that "when wages are rising faster than other prices, targeting the stability price index requires tighter monetary policy.." . This was, nevertheless, the case in Greece in 2008-2010. The country was in a recession and wages were rising. If we adhered to their hard rule then tighter monetary policy would have quite literally financially destroyed the country.

The very essence of sticky prices and sticky wages is that in recessions, they will not respond to changes in the economy by as much as we expected them to. When we wish to target something stable then another stable variable is a good proxy. Yet, when growth and variance of output are in question, we know that they are unstable and more so we do not wish for their stability, thus, a stable variable is not of much good in tracking changes. The CPI is far from perfect; yet targeting wages will not improve our estimates of inflation and neither will it bring more stability in the economy. As the European sovereign crisis indicates, targeting wages will give us the wrong signals. Unless we like deflation and contraction that is.

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