Pent-up inflation

Scott Sumner writes,

There are many reasons why higher wages might not be the optimal way to address a labor shortage. One problem is downward wage stickiness after the economy returns to normal

There is an assumption that “normal” means that you can hire all the workers you want at the same wage rate you were used to paying.

My view: the government has showered the economy with paper wealth, raising the ratio of dollar wealth to wages and prices. The way this will resolve itself is for wages and prices to rise. Firms are in denial about this for now. So inflation remains pent up. I think that prices will rise first, as firms realize that they can make price increases stick and in fact they have to raise prices to ration demand, because they cannot hire enough workers to meet demand at current price levels. Then wages will rise as workers realize they have to seek higher pay in order to keep up with the cost of living. Workers are certainly in a frisky mood, with many quitting and others contemplating doing so.

As I see it, the economy is groping toward a new higher equilibrium price level. The financial markets, and Scott, disagree with me on that.

23 thoughts on “Pent-up inflation

  1. Everywhere I go there are help wanted signs. Everywhere. At the beach in peak season I see establishments flat out closed during the day citing lack of staff. Anecdotally, it seems like some regular stuff like restaurant food is up in price but I can’t show you a study.

    The biggest statistical discrepancy I see is between a very tame Owners Equivilaint Rent and skyrocketing house and rent prices.

    Is the ten year being manipulated in the same way OER is? Or is the current regime really willing to swallow deflation and the market sees that.

    • Same experience. My typical brunch place actually closed down last weekend because they weren’t able to find sufficient staff to open for Sunday brunch. On days they are open, I note they have also done a price hike of sorts by charging an extra 4% to use electronic payment.

      OER is a silly concept. No one pays rent to themselves, therefore there’s no need to include it in any cost of living index. Housing is a durable good just as cars are: have price indexes for new and existing homes, just as there are for new and used vehicles.

      Hedonic adjustments are also suspect. The price of a flagship iPhone has risen 54% since 2016, from $649 (iPhone 7) to $999 (iPhone 12 Pro). I’m sure that gets calculated in the inflation statistics as something like a 50% decline in price because the new phones are better (true!). Yet in order to enjoy that price decrease, you have to downgrade from buying the top tier new release iPhone to the bottom-tier iPhone. By 2025, the flagship iPhone may cost $1,299 and the official price index for iPhones will be down 90% since 2016, but the only iPhone you’ll be able to buy for $65 in 2025 will be dented iPhone 8 with a scratched screen. Wash and repeat for cars, televisions, personal computers – all of those things in which the price has either fallen or not really changed in decades due to hedonic adjustments.

  2. Arnold, your theory about the future of inflation makes more sense to me than any other I have heard.

    But decades of experience have taught me that the financial markets are better predictors than my intuitions about the various theories on offer.

    I would be interested in your theory about why “firms are in denial about this for now.” Markets are sometimes wrong but not in ways that are predictable as far as I can tell. Markets consist of people with their own money and careers on the line who are, by definition, always thinking in terms of bets which tends to put limits on their ideological bias.

    • Prices are being raised across the board, and CPI would be even higher if owners equiviliant rent wasn’t a lagging indicator (actual rents are skyrocketing).

      The question is why bonds yields are so low. That’s the only disconnect. Is that because smart market makers decided on those prices, or because the fed is steamrolling them to their own desires outcome. Nobody considers say the yuan exchange rate market based. Is the ten year the same? Who knows.

      The thing about the fed buying so many bonds is you can’t tell what a “market” price is.

      • Bond yields are more or less always under the control of the Fed.

        There’s also another interesting dynamic: Fed QE creates reserves at banks. These reserves sit around earning almost nothing, severely depressing net interest margin, and so any individual bank will be tempted to use their reserves to buy higher yielding treasuries. However, the banking system as a whole can’t get rid of these reserves that way. When bank A uses $5 billion in reserves to buy treasuries, the amount paid is deposited into bank B, which now has an additional $5 billion of reserves yielding basically nothing.

    • “Financial markets are better predictors than my intuitions about the various theories on offer.”

      For the first half of 2021, annualized CPI inflation (which is understated) rose by 7.4%. What were 6mo T-bill yields at the end of December 2020?

    • Markets were in denial of COVID in February 2020 too, when me and my nerd friends have already been prepping for a month.

      • So, how did things work out for you and your prepper nerd friends vs. the market? Were you able to cover your shorts in time?

        • It’s really hard to predict what the market will do, but at the same token, the market is surprised all the time. The market’s price action in March 2020 was not a good predictor of the direction of the rest of the pandemic, for example.

        • The hardest part about the unit of account not having any solid value is that it’s very hard to turn estimates of the real impact on the economy into bets on nominal prices. As our host notes, it’s obvious that a lot of real wealth was destroyed in the pandemic. Yet, asset prices are massively up.

          How should someone who thought COVID was a big deal approach February 2020? Short because it’s a big deal, or go long because it’s obvious the fed will rain money? Not to mention that each of these narratives had their time in the sun for the first months of the pandemic.

          Is it too much to ask that when business does bad prices go down and when business does well prices go up. At least then people could express their opinion in a straightforward manner.

          FYI GameStop stock is at $169, up from $4. It got “memed” over six months ago. Every short has covered. WTF is happening? It’s P/E is 300!

          • That’s basically my point. “Prepping” for the pandemic “catastrophe” probably yielded them exactly zero in terms of economic gains and probably some losses.

            U.S. stocks were up like 20%+ in 2020. How did they fair vs. that?

            Did they go long on TP or did they miss this one like the rest of us?

            “I am Cornholio. I need TP for my bunghole…”

            https://youtu.be/t6IZ5YSm8sg

            https://youtu.be/aCutOI9F8Ws

  3. An alternative story is that employers can’t get workers because of exceptionally generous government benefits. Eventually, those benefits will phase out, and lots of other supply shortages (e.g., microchips) will ease as production rises to finally satisfy demand and rebuilds inventories to normal levels again.

    Then things will go back to something like the trendlines of the pre-covid equilibrium.

    In the meantime, workers who aren’t sitting it out are in extremely high demand, and so poaching is at all-time high, leading to lots of ‘frisky’ quits. This is definitely true where I work, which is otherwise about as insulated from the business cycle and overall economic conditions as one can get.

    So, in this story, employers are not necessarily ‘in denial’ so much as they are trying to hold out for things to get back to normal. Raising prices now might alienate and upset customers, and raising wages above where they’ll settle will be hard to reverse and make a business uncompetitive.

    If that’s right, then what you might see is a lot of employers offering generous one-time signing bonuses but keeping wages steady. But they’ve still got to pay for the signing bonuses, which means equally temporary price increases in the most inelastic areas, but then these things gliding back down to normal.

    Finally, this is far from the first time the government has showered the economy with paper wealth, which given the increase in asset prices does seem to me to be a valid alternative way to think about ‘inflation’. But in terms of non-housing price level inflation and wages, it didn’t seem to do very much in previous rounds, unless the counterfactual was some pretty significant deflation.

    • The real question in my mind will be whether or not otherwise stable employees will balk at the usual 2% wage hikes at year end, if measured CPI turns out to be 5%+ for 2021. Inflation is certainly on the radar screens of my team at work – everyone is talking about it.

      • I’m wondering about this too. My guess is that the Christmas bonuses will be generous this year. Maybe there will be more promotions (merit pay raises) as well.

  4. This all ignores the question of workforce diversity.

    What has happened is a huge wealth transfer to the zero marginal worker.

  5. “There is an assumption that ‘normal’ means that you can hire all the workers you want at the same wage rate you were used to paying.”

    I don’t think that’s what Scott means. There is a lot of (temporary) demand right now due to fiscal stimulus and perhaps people eager to spend as they are released from Covid restrictions. There are also (temporary) labor supply cuts due to extended unemployment benefits and perhaps lingering Covid fear, workers re-evaluating their post-pandemic priorities, etc. “Normal” means when these temporary factors subside. The problem of downward wage stickiness does not refer to inability to “hire all the workers you want at the same wage rate you were used to paying”. Once the temporary factors subside, then the market-clearing wage rate will drop. Downward wage stickiness, however, will prevent nominal wages from dropping along with the market-clearing wage, leading to unemployment.

    It’s not that employers feel entitled to “hire all the workers you want at the same wage rate you were used to paying”. They anticipate that extended unemployment benefits will eventually expire and so will the current demand surge. Ditto the other temporary factors that are currently contributing to the temporary labor shortage. They are reluctant to raise wages now, knowing that it will be difficult to lower wages later. Then, they will be stuck with a high expense burn rate when demand subsides. Reluctance to respond to a temporary situation with a quasi-permanent change is different from inertia or clinging to the past (wages one was “used to paying”).

    I encountered the reverse situation during my last lease renewal. The pandemic had lowered, at least temporarily, market-clearing rents in cities. However, instead of renewing at a lower rental rate, my landlord offered me two months’ free rent concession (17% reduction in total 12-mo rent, but no decrease in nominal monthly rental rate). I suspect that they are hoping that rents will rebound by next year. If so, then they will drop or reduce the rent concession, which I think that they think is easier than (re-)raising nominal monthly rental rate. (It’s also possible that a “one-time” rent concession has less impact on the valuation of the building and/or the landlord’s company than would a reduction in recurring rental income.)

    Similarly, employers seem more willing to offer one-time hiring/retention bonuses than recurring wage increases right now.

  6. I think you are missing the more obvious outcome. If we have inflated paper wealth to wages/productivity then to equalize we can just destroy a large amount of that paper wealth. Bitcoin dropping by 50% has already done some of the heavy lifting here, if the stock market drops by 33% (which would only take us back to pre pandemic levels) and housing prices declined by 20% then you are basically neutralizing the paper wealth creation. This is, I think, a fair sketch of what happened to Japan in the 90s.

    • The Biden administration and the DNC won’t be happy with -33% S&P 500 or -20% HPI heading into the 2022 elections. That’s a somewhat mild version of 2008, but certainly enough to get them to lose Congress.

  7. Real wages are negative which might be a contributing factor to workers not grabbing jobs as well as Joe’s aid and the matching issue.
    Lot of companies are not able for now to pass through to consumers the increase in raw material prices any number are and have been seeing. In fact, for a great number of companies any sales increase or maintenance of sales levels has been a result of higher prices and not increased volumes of units sold.
    If the consumer actually does not increase buying of goods and services, not likely to see wage increases, particularly with the likely increased corporate tax.
    Now if inflation looks to be embedded via future data, and employment not pick up as Fed would like, Powell and Co. will be caught in a rock and hard place.
    Stagflation risks seem to be increasing and what will be interesting to see will be point in time in near future where GDP comes in under forecast but inflation still too high.

  8. A curiosity is that measured inflation remains below 2% and often near 0% in such nations as Japan, China, most of Europe, and Southeast Asia.

    So the US is the outlier here in terms of measured inflation, but it is difficult to determine if the monetary and fiscal stimulus has been any larger than in nations such as Japan or China.

    This suggests that what is presented as axiomatic in macroeconomic theory may actually apply only to the US in actual practice, and then only variably. Notably, inflation was mild after 2008.

    And as I always say, if you really want to stick a spear through the heart of inflation get rid of property zoning, and then you will see housing costs stagnate for several decades.

  9. Easy fiscal and monetary policies have boosted the PRICE LEVEL higher than the pre-pandemic trend. Agreed. The level of prices and wages will never return to the old trend.

    The big issue is whether we see a higher sustained inflation rate. That is another issue. I am inclined to think not under the view that the budget deficit is falling and the Fed will tighten soon. I could be wrong. The Fed views current higher inflation as transitory.

    There is an analogy to the post WW2 period. Personal savings were high as the war ended because people had nothing to spend on; they bought federal debt (mostly through their bank accounts). The Fed pegged interest rates low even with massive war deficits. The current lockdowns are analogous to the rationing and price-wage controls of the war period. And the destruction of the war was like the disruptions to the global supply chain now. When the government got rid of rationing and price-wage controls after the war, the paper wealth got spent, pushing prices to market clearing levels. A permanently higher price level but inflation dropped to low levels.

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