Graph of the Day: Just how tight is the relationship between inflation and wage growth? (Answer: not very)

August 19th, 2014 at 3:09 pm

There’s been of late an interesting outpouring of quality research on one of my favorite topics: the relationship between labor market slack and wage growth. I’ve got a longer piece on this coming out later, but the punchline is, as you probably know if you’re drawing a paycheck: considerable slack remains in the job market and it’s still a drag on the real wage growth of most workers.

I’ve got links below to the pieces I cite in my forthcoming analysis, but here’s a figure I think deserves more attention than I gave it, from this new paper by Knotek II and Zaman, economists at the Cleveland Fed.

It takes a bit of explaining. The lines in the figure show the errors from a model designed to predict inflation. (A BVAR is a Bayesian Vector Auto Regression, which sounds a lot weirder than it is: it’s just a way to tease out the ways in which a bunch of economic variables effect each other, with few restrictions placed on the model). As you go down the X-axis, you’re forecasting further out in time, so as you’d expect, the errors grow.

But what the researchers were really asking here is whether adding wages to the model improved its accuracy. After all, there’s a lot of folks running around claiming that unless they want to face uncontrollable (or un-anchored, in Fed jargon) inflation, the Fed better take pre-emptive action against incipient wage growth. Yet, as this and other analysis in the paper reveal, linkages between  wage and price growth are but weakly correlated. Adding various different wage series (that’s what those acronyms are: AHE, CPG, ECI) to a forecast model for inflation hardly improves its accuracy at all.

What’s the implication? It’s that Fed policy makers should not assume that wage growth is de facto inflationary. Go ahead and keep your powder dry, FOMC, but in the words of my monetary policy mentor, Dr. Robert Marley, when it comes to wage growth, don’t “kill it before it grows!”*


Source: Knotek and Zaman

*You know the original lyrics, right?

I raised the funds rate!
But I did not raise the discount rate.

Oh no, oohhh

I raised the funds rate!
And they say it will make capital less tense.

Relevant links:


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3 comments in reply to "Graph of the Day: Just how tight is the relationship between inflation and wage growth? (Answer: not very)"

  1. Some guy says:

    Solid post…and good music.

  2. Some guy says:

    On a semi-related note, EPI just published a really good paper on the long-term unemployed.

    Key quote regarding wages:

    ” The weight of the evidence shows that the long-term unemployed as a group have put downward pressure on wages, which indicates that they are a meaningful component of remaining cyclical weakness and have not “hardened” into structural unemployment.”

  3. Nhon Tran says:

    Thank you. I think the relevant measure is wage cost per unit of output, that is wage relative to labour productivity?