Subdued Inflation: why a wage spiral enduced inflation is unlikely now in America

Free Exchange, the Economists' economic blog, has a fantastic post today that summarizes today's unemployment numbers, the labor force, and inflation (expectations). The thrust of the post talks about our economy's "new normal": That is, an economy that is failing to provide more jobs than the rate of population growth which translates into structurally higher unemployment. A side emphasis provided in this post makes the argument that both headline and core inflation - measures of inflation based upon volatile commodities like oil on the one hand, and more stable prices that are "sticky" (sticky and non-sticky prices will be discussed later) like labor prices and home mortgages - are subdued because workers aren't receiving higher wages because the "price" for labor is still very low. If workers don't receive higher wages then aggregate demand stays the same, all things being equal. This stagnation of wages keeps inflation expectations subdued because if aggregate demand remains the same then firms don't raise prices for their goods because they know consumers will demand less of those items. But once wages begin to rise for reasons such as excess credit, or money sloshing around, or because the economy is operating at full capacity and unemployment figures are low, then inflation expectations begin to rise. And if the Federal Reserve doesn't act quickly then what ensues is a price-spiral inflation scenario: higher wages leads to higher prices and higher prices forces workers to demand higher wages given their decreased real purchasing power (i.e they can't buy as many items as they did with the lower wage). This spiral can be very painful to correct. It requires the Fed to lift its funds rate and sell treasuries, effectively taking money out of the economy. That sounds nice and easy but it is also a recession because with lower prices, firms must lay off workers to compensate for lower profit margins. We've only just escaped a global recession and near depression so any measure to avoid a double-dip should be welcomed. I digress. This emphasis on subdued inflation expectations directly contradicts attacks upon Ben Bernanke and the Federal Reserve for their optimistic opinion that inflation will remain low, notwithstanding the Fed's recent securities purchases via QE2. 


Here's my response to the Free Exchange post:


"Hourly earnings did not grow, so the yearly increase fell back to 1.7%. Even if gasoline is about to lift inflation, it’s hard to see a wage price spiral developing."

You answered my burning question: Is the surge of criticism leveled at the Fed's policies justified? I've been reading a couple of columns at Seeking Alpha that claim headline and core inflation are going to rise given higher oil prices and extra money sloshing around in the economic system. But with unemployment still high, isn't it true (theoretically) that a wage spiral won't necessarily ensue because workers don't have the ability to negotiate higher wages given the low price of labor? There's so much spare capacity and so many workers seeking jobs that employers don't need to offer higher wages - which would effectively lift inflation and inflation expectations - to current employees, right? Headline inflation is a very volatile piece of data because oil prices could drop tomorrow, alleviating the indirect tax that consumers incur, making moot the discussion of whether or not employees need higher wages to cope with higher oil prices. Once unemployment numbers begin to fall to levels more consistent with an economy operating at full capacity, and once the labour force percentage grows higher than 64.2% , THEN the Fed should consider raising interest rates and selling bonds to soak up money that was injected recently to push down long-term borrowing rates.

We need to be very careful not to pull out support to the economy in the form of securities purchases and money injections by the Fed lest we squander the failed recovery underway right now. If however, wages begin to rise in aggregate, and core and headline inflation expectations rise as a result, then the time will come when the Fed should set higher interest rates on its funds rate, the rate at which banks lend to one another, and the Fed should also begin to withdraw money from the economy via selling bonds. 

Here's a link to the most recent unemployment numbers; down to 8.9%. Not perfect, but improving. And here's a link to Chairman Bernanke's testimony at the Senate Banking Committee during which time he claims emphatically that higher oil prices following unrest in the Middle East won't lead to higher inflation. Both deserve your attention.