Good News! Inflation!

Written by John Eckstein- Director of Research at Astor Asset Management, LLC

While we all wring our hands about inflation and grim-faced, serious-suited bankers tisk, the fact that we have had an uptick in inflation in 2011 is good news. That and the prospect of a bit more is putting the United States into a position where job creation – and demand creation – is more likely. To explain why, I am going to call upon our trusty friends, supply and demand.

Economists usually think about supply and demand balancing on a graph that shows the quantity of a good demanded on one axis and the price of the good on the other with the price representing what would be obtained in the marketplace and sampled at monthly intervals perhaps, showing at each price where supply and demand met: this many dollars for that many cookies. The chart shows one representation of the US labor market with total labor (in terms of total hours worked) on the horizontal axis and the real (or inflation-adjusted) wage on the vertical axis. Recall what happened at the end of 2008. Many, though not all, economists would describe that period as one characterized by a sharp drop in aggregate demand, that is on the whole the US decided to consume a lot less of some things (houses in Las Vegas for example) and somewhat less of almost everything. As consumers demanded less, producers made less and thus there was less demand for labor. Now if the demand for something goes down: why then our ancient faith should teach us that the price should usually drop as well. Look at the red squares on the chart though: they represent the period 2009 to date and you will see that the real wage – the price of labor – increased over this period.

This scenario seems odd. Of course employees did not find a note on their paystub saying: “business is terrible, have a raise”, but the CPI dropped substantially with no change to the trend in nominal wages – causing inflation adjusted wages to increase – and until the end of 2010 both prices and wages moved together, keeping real wage at its new, higher level. Now it’s a bit of a puzzle why wages wouldn’t fall during a recession. The same thing happened, though not to the same extent, in the 2001 recession but wages fell, as you would expect, in the 1990-91 recession. Logic dictates that if more workers are to be hired they must be hired at a wage firms find attractive but there seems to be a bit of disconnect between the real world and the ultra-rational economic factors our models posit.

Whatever the cause of the increase in real wages, with inflation rising faster than wages over the last few months, we have begun to see some progress toward moving wages nearer to the level they were before the recession started. Call it half way there. At this point we are in the unusual situation of hoping for a bit more inflation and sooner rather than later. Enough inflation, that is, to move the real wage down to induce firms to hire more workers (thus increasing demand and – hopefully – moving the real wage back up again but for the “right” reason) but not high enough to force the Fed to hike rates prematurely. Incidentally, increasing inflation somewhat would also reduce the real interest rate which is good for getting money into the hands of firms who can invest it.

According to the Fed’s semiannual monetary report to Congress from this winter, increasing inflation to more normal levels was one of the goals of the second round of quantitative easing undertaken by the Fed which is due to end this month, Interestingly, one idea which keeps coming up in discussions of Fed thinking is inflation targeting, where the fed explicitly aims at a target for inflation, with a balanced approach of reacting to inflation either over or under the target.

Of course the real wage is not the only thing going wrong with the US economy and it is easy to overdo it with inflation. I believe, however, the recent moves are moving the US labor market towards a higher employment equilibrium.

John Eckstein is Director of Research at Astor Asset Management, LLC