The Trouble with Low Inflation

May 1st, 2013 at 6:50 pm

The Fed announced today that they’ll continue to be the only ones in town trying to do something about the stubbornly high unemployment rate:

The Federal Reserve said Wednesday that its stimulus campaign would press forward at the same pace it has maintained since December, putting to rest for now any suggestion that it was leaning toward doing less.

Another symptom of our demand-weak economy, along with high unemployment and weaker job creation, is the recent deceleration in price growth, shown in the figure below.

The Fed’s “…statement also noted that the pace of inflation had slackened, a potential sign of economic weakness, but it showed little concern about that trend.”

Me, I’m pretty concerned about that trend.  On the one hand, lower price growth means higher real wages, all else equal, and that’s important as slower nominal wage growth is another problem right now.

But on the other hand, low inflation is problematic in ways that are less obvious than the real wage story above.  First off, faster inflation means lower real interest rates, and since the Fed’s already at zero (and can’t go lower), a bit more inflation would help in that regard.  I’d bet we’d see more investment bucks move of the sidelines if that trend in the figure were to reverse course.  Higher inflation also chips away at nominal debt burdens and thus hastens deleveraging.

But the deeper, and more interesting, reason one worries about too-low inflation right now comes out of the work of Ackerlof et al back in the mid-1990s.  It has to do with sticky wages, something Keynes recognized as contributing to intractably high UK unemployment back in the early 1920s.  Back in the mid-90s, we also faced a period when price growth was slowing, and inflation hawks called for the Fed to set zero as their inflation target.  Greenspan apparently took it seriously, and internally debated the idea.

That inspired Ackerlof et al to think about what might happen in a zero inflation economy, and what they found was that it would engender significant costs in terms of unemployment and growth.

The reason that zero inflation creates such large costs to the economy is that firms are reluctant to cut wages. In both good times and bad, some firms and industries do better than others. Wages need to adjust to accommodate these differences in economic fortunes. In times of moderate inflation and productivity growth, relative wages can easily adjust. The unlucky firms can raise the [nominal] wages they pay by less than the average, while the lucky firms can give above-average increases. However, if productivity growth is low (as it has been since the early 1970s in the United States) and there is no inflation, firms that need to cut their relative wages can do so only by cutting the money [i.e., nominal] wages of their employees. Because they do not want to do this, they keep relative wages too high and employment too low. [my bold]

As long as there’s a little inflation in the system, “less fortunate” firms can give nominal wage increases below the rate of inflation, allowing them to adjust to harder times.  With very low inflation, they don’t have the room to pull that off.

Now, I suspect some readers are thinking “hmmm…real wages too high?…that doesn’t exactly sound like our problem right now or anytime soon.”

You’ve got a point.  To the extent that worker bargaining power is so weak that firms can just jam wages down as much as they like, the fundamental sticky wage part of story disappears.  But from what little recent evidence I’ve seen, nominal wages for incumbent workers are still pretty sticky.  If you’re lucky enough to have a job, think about your own case.  I suspect you haven’t seen much in the way of raises, but has your salary actually been cut in nominal terms?

If not, and as long as demand remains weak in our 70% consumption economy, with fiscal policy pushing the wrong way—note that Bernanke and Co. dinged the Congress in today’s statement: “…fiscal policy is restraining economic growth”—firms will continue to want to “adjust” wages.

The fortunes of firms continually change, and inflation greases the economy’s wheels by allowing these firms to slowly escape from paying real wages that are too high without actually cutting the wages they pay. This adjustment mechanism allows the economy to avoid a large employment cost. At very low rates of inflation and productivity growth, such adjustments are short circuited, and employment suffers.



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12 comments in reply to "The Trouble with Low Inflation"

  1. Perplexed says:

    What better evidence do we need than the Akerlof, Perry, Dickens study to show that unemployment itself is the result of price collusion between employers and “existing” or “current” employees to benefit both at huge cost those currently not members of the “club.” In what other “market” would such price collusion be permitted. How does the “science” of economics defend this position? There are many other solutions i.e. reduced hours or workweeks, job sharing, job rotation, full compensation to those forcibly “excluded” from the “market.”

    How does legalized price collusion become the preferred (and politically supported) option? Maybe “science” should look seriously into this unexplained “mystery.”

    • Lori says:

      Did you forget that most jobs went to China and Asia? The wages must have already fallen, because the last 30 years they are stagnating, but profits and earnings are booming no matter what is happening to the economy. This theories does not apply to crony capitalism with such divisive distribution of income and wealth, it is just cheap propaganda, which has to legitimate QE1,23,4….n, for ever.

      • Perplexed says:

        -“Did you forget that most jobs went to China and Asia?”

        Would the political support for the trade policies that produced these results have existed if the costs of unemployment had been shared by all instead of “dumped” on a few while sparing everyone else? Would the preferred solutions of the wealthy to worry about debt instead of unemployment been politically feasible if all were absorbing the costs of these misguided policies?

        Allowing this as a solution is indefensible and prevents the discussion and selection of any ethical alternatives.

  2. bakho says:

    Inflation that is too low makes it difficult to reset relative pricing of all sorts. Inflation can be built into borrowing. If wages and prices are 50 percent higher after 10 years, then buying a house will be easier with future dollars or buying an education. At very low inflation, how does a college grad see the wage increases needed to pay off loans? There are a lot of things that make economic sense with inflation in the 3-4 percent range that all fall apart at 2 percent or lower. Absolute wages are important. Too little thought is given to wages, especially at the low end, but wages are a big issue.

  3. The OutSourced One says:

    In today’s world firms cut wages by in-sourcing jobs to guest workers brought here on visas and then firing the high-paid US citizens. To provide political cover for this act they usually move the jobs to a different state and then complain of “worker shortages.” This practice also generates “Good Press” in the moved-to state which makes the firm look good.

    This is why the unemployment rate for Software Engineers, one of the top 3 jobs in the US by some surveys, is currently double what it was prior to the Great Recession.

    The other alternative, cutting the salaries of the existing workers only leads to a resentful workforce that comes in late and leaves early and where the best workers jump ship to a competitor.

    So one result of too low an inflation rate is chronic unemployment of fully trained and otherwise productive workers in their 50s, and proclaimed “shortages” of H-1B visas.

    As an aside, I don’t understand why the proposed immigration bill is not getting more coverage on the economic blogs. The addition of tens of millions into this job market over the next 10 years would seem to have a bigger impact on the economy than the actions of the Fed.

    Also, it is clear to me that Bernanke’s Fed now seems to be moving to counteract the harmful actions of Congress, such as the sequester. I wonder what actions the Fed will take in response to the dumping of tens of millions of new workers into the US labor market? Perhaps the Fed can undertake the direct repayment of student loans on behalf of US graduates?

    • Perplexed says:

      -“Perhaps the Fed can undertake the direct repayment of student loans on behalf of US graduates?”

      It is very curious that now that O’Bama has “eliminated the middle man” (and put an end to at least this form corporate welfare to banks) that student loan rates are still in the 7 – 10% range when the government borrows at less than 2%. That’s a pretty huge margin for loans that can’t even be discharged in bankruptcy.

      Instead of increasing our commitment to funding education, I guess its now viewed as a profit center for the government.

      • David B says:

        On top of that, those loans aren’t just creating direct funds, they’re viewed as creating more funding for both state and federal educational coffers. The huge issue comes from the fact that as the gov’t backs giving higher and higher amounts of guaranteed loans, the schools take that into account, build it into their pricing and raise tuition significantly. They’re riding on the fact that to get a top end job, you pretty much have to have at least an undergrad now and everyone has the funds available, so everyone can pay at least the amount of available loans from the federal govt. Basically fed gov starts loaning 10k/yr, then pretty much all schools up tuition 10k/yr. Its just artificial inflation and now Universities are directly lobbying congress to keep increasing stafford loans. Its a joke.

  4. annoporci says:

    And this is where, once again, it matters whether the economy is far below capacity and in serious lack of demand, because that’s where a fall in real wages has a more negative effect on the demand channel than it has a positive effect on the supply channel, Akerlof and friends (AK not ACK), they mostly focus on supply-side channels, because they have in mind the typical recession, not the crazy recession of the 1930s or 2008. So the relevance of their work to this recession is small indeed. (I love Akerlof, but I just don’t think this line of work is of great relevance today)

  5. timm0 says:

    I work in a large company with over 100,000 employees. The approach taken here is “voluntary layoffs” offered with the same exact terms as previous INvoluntary layoffs. Hence the message is, “get out now, because when we start kicking you out, you’ll get nothing.”

    While shedding thousands and thousands of 50ish workers, they have diligently brought in wave after wave of recent college grads. There’s not much stickiness of wages going on for those who have left or been thrown out when programs end. The next phase is to use accounting tricks that place everyone into pay grades that slide to the left, thereby eliminating future raises.

    I suspect wage stickiness has more of an impact on smaller companies who have less of an ability to quickly recover from the loss of one or three key employees. Large and service-type organizations, however, have no problem with dropping pay at all. The race to the bottom is in its final stages.

    Welcome to Manila.

  6. David B says:

    To respond to a few points:
    Jared, yes, I have had multiple friends directly have their wages lowered without any respect for performance, some to the tune of 20-30%. These are mainly at small businesses by shrewd owners. They are relying on the fact that these people have obligations (rent/mortgage, car payments, utilities, children, etc.) and do not have the ability to quit or negotiate for a better wage.

    I feel that the view of rising inflation allowing graduates to more quickly pay off student loans is absolute crap. The price of an undergraduate degree rises about 6-10% a year currently, easily outpacing anything short of a dangerous rise of inflation. Inflation may remove some company’s flexibility in terms of wages with their employees but that assumes a perspective of viewing employees simply commodities or rented equipment. The other piece of the puzzle is that wages are a negotiated payment, to decrease wages without performance issues is a company backing out of agreements.

    The brunt of inflation is carried by low wage workers who lose buying power with inflation increases. Market Inflation in respect of wages only helps companies when the value of wages is not adjusted for increases in inflation. As soon as minimum wage is increased, then all those same companies will start talking about the issues with inflation.

    I know a lot of this was a bit of a rant. The main point for me is that damage that is done to the common man is a larger issue than lowered inflation is for business.

  7. Lori says:

    It is ridiculous to think that the wages are too high and that’s why the economy does not grow. If the economy didn’t grow how could the financial assets grow more than 30% only for the last year? Where does those corporate profits and earnings come from? The whole story with high wages as a cause for unemployment is a great bull s***.

    If the money, which FED pours to the banksters’ pockets were given to the government (for free, like they are given now to the banks) to spend for infrastructure and mortgage aid for working families, the economy would be booming by now. Instead FED initiated the greatest scheme for middle class wealth redistribution on behalf of the greedy banksters and Wall Street.

  8. Bob says:

    Low or no inflation pushes government employee wages higher and higher. As these saleries never go down. College professors, police, firefighters, etc.

    They also seem to have pushed ceo pay higher and higher. Not sure if it is With easy money it is easy to leave and borrow money to start a similar firm or just look at everyone pay should I be making 60-70% of the average pay. Combined with no inflation to counteract.

    It also rewards bad businesses that are only alive because of easy money at the expenses we’ll run companies.