Is Inflation like Cooking with Gas?

Cartoon by Jim Gibson

If you ever want to be really popular at a cocktail party or a high school swim meet, just drop the term “unit labor costs”. I jest but now I have your undivided attention at least until you get a text from your local pizza delivery service.

I would not say that unit labor costs (ULC) are the key to world peace or eternal personal salvation but I would claim that ULC is the least known and most helpful economic indicator for understanding the economy and especially what will come in the way of future inflation. Most of us are riveted now to stories about the Fed and I will not discount the fact that Fed policy is critically important to future economic growth and inflation. But let’s face facts, even if her majesty Hillary Clinton were to become the next Fed chair, we would still be stuck with ULC and she would have very little to do with that. What I show below is that sub-par inflation today is the result of two labor market factors – the rate of labor usage and wage increases. If these are temporary aberrations that disappear as we exit a very slow growth period, then we should be worried about inflation. But if longer term forces are at work in the US labor markets, then inflation could remain tame for some time despite massive monetary overhang.  

Most of us have learnt well that inflation is all about too many dollars chasing too few goods. Many of us have tattoos that say as much. Since the Fed is in charge of how many dollars rain down on the economy we usually associate inflation with Fed policy and how that policy affects our decisions to spend and/or save. The typical story is that the Fed injects money into the system, thereby reducing market interest rates, resulting in flash mobs at your local car and real estate companies.  All that new demand for goods and services, according to this tale, stimulates Charlie Sheen and others to buy stuff and this increases output, employment and prices.   It is a demand-side story and it is told over and over and over in our universities and art galleries.

I am not writing today to deny that story though if you will look at my thousands of past posts, you will find plenty of ammo that suggests some inconsistencies in that theory. But today is instead about why that story isn’t enough. It is a nice macro/market story but it doesn’t really get into the nitty gritty of price setting. Price setting is done by firms. Companies do not change their prices randomly and in the US most firms do not get a note from the government telling them what price to charge today. Clearly the demand for a company’s goods is important to the price setting decision but much also depends on internal production issues.

Economists believe that companies either seek profits or market share when it comes to pricing. When demand increases that will get their attention. But will meeting that extra demand mean a larger profit? To know if more production will generate larger profits the firm has to answer two questions – how productive is the labor input? and how much will the extra labor cost?

Unless a company has excess labor sitting around eating handfuls of chips loaded with onion dip, a sizable permanent increase in output usually entails more workers or more worker hours. Suppose there is a demand for 100 more units of chicken noodle soup. If in one company the workers are not very productive but they are expensive, that company might not make much money by meeting the extra demand. In another company the workers are highly productive but not as expensive then that company might expect higher profits from meeting the extra demand. Depending on the productivity and labor costs either company might want to raises prices to bring in even more profits – but that might come at the expense of market share.

The point is that a demand change is not sufficient to predict changes in employment, output, or price. We also need information on what is happening to productivity and compensation costs. Which gets me to today’s topic. Despite the Fed and despite record attempts at stimulating demand in this country, we have not seen much inflation. The table below helps us see why we have seen lackluster inflation and gives us some pointers when it comes to thinking about the future and what might happen to inflation once we distance ourselves from the world recession.

I compare the last five years (2007 to 2012) of recovery from the recession (first column of the table below) to a similar period in the previous five years (2002 to 2007, last column). Using two different measures of inflation (based on the GDP price deflator and the CPI) it is clear that the last five years has shown a marked decline in inflation. Inflation has been growing at a little more than half of the previous period. We see this behavior has a lot to do with ULC. ULC measures the cost-side. It tells you how much more it COSTS to produce an additional unit of output. Firms didn’t need to raise prices much in the second period because their costs per unit of output were barely rising. Whereas ULC grew at more than 8% before 2007, they grew at just a little over 1% since 2007. That  is a remarkable change in the cost of producing an additional unit of output.

The table helps us to understand why business costs have been rising so slowly. Notice that in the last five years, labor compensation rose by 11.2%. That is half the rate of the previous five years when compensation increased by 22.2% rate. Productivity, in contrast, could not keep up the former pace of almost 13% but did manage to grow by nearly 10%. The decline in productivity growth means added costs of production but this upward impact on costs was swamped by the rapid deceleration of labor compensation.

The productivity part of the story is interesting. The decline in productivity had two major sources. First, total output of firms grew by only 3.9% in the past five years – much slower than the 18.4% in the previous five years. Equally dramatic was the reduction in labor hours – which showed a decline of 5.3% in five years. Firms were using fewer labor hours in 2012 than they did in 2007. Productivity has grown recently because firms have dramatically cut back on employment and hours worked.

We summarize all this as follows:

• Inflation is lower because costs per unit of production are growing more slowly.
• Costs per unit are growing more slowly because wage and non-wage compensation have slowed and because firms have cut back on employment.

The US economy is growing and output is rising albeit at a modest pace. The usual situation is that once the economy’s growth returns to something more normal, compensation growth will accelerate and employment will expand. This natural progression implies that productivity growth will decline, ULC changes will increase, and inflation will rise. It’s like microwave popcorn. Put the bag in the microwave, set the timer to 3 minutes, remove the bag when the popping stops, open the bag and add a little salt. Then eat. It’s like cooking with gas.

But is inflation like cooking with gas? Is it going to come back when economic growth resumes? Or will longer-term factors impede the usual employment, wage, and benefits progressions? What do you think?

                              Table: Percentage Changes

      2002-2007              2007-2012

Hours                            4.5                        -5.3

Output                         18.4                         3.9

Productivity                  12.7                         9.7

Compensation/Hour      22.2                       11.2

Unit Labor Costs            8.4                          1.4

Unit Non-Labor costs   17.3                        14.8

Inflation (GDP deflator) 11.9                          6.8

Inflation (CPI)               15.2                        10.8

Sources:  http://www.bls.gov/news.release/prod2.t06.htm

ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt