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 rule, inflation 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.

A History of Stagflation and Recent Experiences

When a person is asked what is the worst economic conditions one can think of the most common answer is, of course, high unemployment. We all know what unemployment means: people have no jobs, consequently no money to live by and the welfare of an entire nation is at stake. It just takes a look at the current situation in South Europe, especially in Greece and Spain, to understand that high unemployment can have devastating consequences. What makes life slightly easier for the unemployed is the fact that prices tend to fall when unemployment rises, as the Philips Curve claims. Yet, when a nation has to deal with high inflation and high unemployment simultaneously it faces a situation called stagflation.

The 1970's were such a period; in the UK, a recession caused the unemployment rate to rise by approximately 83% in the 1970-1979 period as it took about 14 quarters for the UK GDP to recover to it's pre-recession levels, with the overall output decrease at 4%, or about 1.5% in real terms if one uses the Bank of England data. Yet, even though the rise in unemployment was tremendous, the maximum value reached in the 1960's was just 4.2%. Yes, that is just 4.2% of the labour force and no it is not a typo. In comparison, only Austria had an unemployment rate of less than 5% in June 2013. Then why complain about growth?

The difference here was inflation. Inflation rose by an astonishing 200% in the 1970's, with annual rates reaching 24%. The starting value of inflation was not really that low either: in 1969, inflation was more than 5% while it rose to 24% in 1975. On average, the yearly inflation rate in the 1970's was 12.5% higher than any other period in the UK's history.

What is odd is that the term stagflation was not coined in the 1970's as one would expect. It was in fact first uttered in 1965 by a British politician, Iain Macleod, who warned about the situation "We now have the worst of both worlds—not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of “stagflation” situation. And history, in modern terms, is indeed being made."

This, however, was a rather strange conclusion: inflation in the 1960-1965 period was 3%, the unemployment rate was 1.5% and GDP grew on average 3.1% in real terms. Neither was the situation bad during the previous decade: in the 1950's output grew by 2.31% in real terms, unemployment was 1.24% and inflation was 4.3%, something which can be attributed to high growth during the years after the war (indeed if one excludes 1950-1953 the average inflation was 3%). Thus, what made 1965 different?

My guess is nothing. In fact, stagflation in the UK would not appear until the 1970's and the only pertinent issue was the level of inflation at a moderately high 4% in the 1965-1970 period. Yet, in no way did high inflation cause a stagnant economy. The next graph indicates the annual real GDP growth for the UK.

In the 1960's only once was real growth low, and this was at 1%, not something which would cause distress and something that South Europe economies would crave for at the moment. Inflation was indeed an issue; one which was due to policy (high government spending in periods of full employment). Yet, policy alone would not have created such an issue if oil prices had not skyrocketed in 1973-1974. To day, this has been the largest increase in oil prices, causing a major supply shock inflation which caused inflation to rise. The two major shocks in the decade, in 1973-1974 (252%) and in 1978-1979 (125%) were the main causes of recession. In total, oil prices increased by 1504% (that is 15-fold) in the 1970's.

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This, compared with a much greater dependency on oil than we currently have, caused the shock which came to be remembered as stagflation. The initial conditions had also been favourable: increased government spending in times of almost full employment caused higher than normal inflation and set the background for an even larger increase in inflation when the oil shock hit the world economy. Emphasis here should be made to the following point: as with hyperinflation, policy alone could not have caused stagflation; The oil shock was necessary for the situation to unfold and we would have not witnessed this part of history if it wasn't for it.

How about the politician's quote then? What triggered his comment if inflation was not higher than before and growth was still good? There are only two possible explanations: either he could see 7-8 years into the future or he was comparing with what had happened before and highly exaggerated. The first explanation is rather strange given that if he could do that he would have have made himself a very rich man, while the latter is more plausible if one looks at the data. According to the data mentioned above, inflation was higher by 1% and unemployment by 0.25% then the previous decade; strangely, GDP was growing by more during the time of his statement. It appears that the whole issue has been one of comparison between what the economy was doing and what the economy did. As politicians are more prone to dramatize situations than most people are, a subtle change in the economy (although percentage-wise the increase in unemployment was 20%) would spark just such a comment, especially if one thinks that Macleod was a Conservative while government was led by the Labour Party which had won a narrow victory in 1964. 

I wouldn't dare suggest that a period which satisfied the name and definition of stagflation never existed. Yet, the definition preceded the actual situation by more than 7 years, with no data or developments supporting the initial claim, which makes us wonder whether the statement had nothing more behind it than mere political agendas, since indicators just slightly deteriorated during the 1960's (with real GDP actually increasing). In addition, even though the recession was quite real, stagflation would not have justified its name had there not been a dramatic increase in oil prices.

Concluding, even though a resurrection of those who promote that stagflation would be an issue in the near future, I would just note that inflation both in the US as well as the EU and UK is falling and unemployment is much more stable (although higher) than it was a year (or more) ago. In addition, oil dependency has decreased over the years as alternative sources of energy emerged: solar, nuclear, geothermal and most importantly gas. Although I would not go as far as to declare that stagflation cannot occur, it would take a much more severe shock than the one in the 70's for it to take place.

Note: All data for the UK, including Oil Prices were extracted by the Bank of England's Three Centuries of Data file (.xls)