To hear mainstream economics and financial journalists, the ongoing economic recovery means that unemployment is falling, leading to rising wages, which in turn will to an increase in the price level. Therefore, the Fed should raise interest rates before the situation gets out of control.
Let’s see if we can’t unpack the connections between wages and prices, and to introduce an element the economists and journalists don’t ever mention: corporate profits.
First, as we can see in this first graph, there is in fact a correlation between unemployment (not the official measure but, instead, total or U6 unemployment) and wages (the year over year change in hourly earnings of production and nonsupervisory employees): in general, since the early-1990s, as unemployment falls (and workers have more bargaining power), wages have a tendency to rise.* But the correlation is not perfect; especially in recent months, the unemployment is continuing to fall but the rate of wage gains is also falling.
Second, as demonstrated in the second graph, there is no correlation between wage gains and inflation. Nominal wage gains have been very low for decades now but inflation has been all over the map, from a low of negative 4 percent to a high of about 11.5 percent and pretty much every level in between. The economists and pundits may claim wage increases threaten to provoke inflation but they’re hard-pressed to show that relationship empirically.
It is clear from the third and final graph that there’s a missing element in the usual story: profits. Again the correlation is not perfect but there is a clear relationship between the change in profits and the change in the price level. How do we interpret that relationship? Basically, corporations attempt to set the prices of the commodities they sell in order to realize profits. In general, a surge in profits is accompanied by an increase in prices while a slowdown in the growth of profits leads to a lessening of inflation.**
The conclusion? Workers’ wages certainly depend on the amount of unemployment but inflation is caused not by wage increases but by the rise in corporate profits.
*Except in the usual neoclassical story, the direction is in reverse: wages cause unemployment.
**Corporations, of course, don’t have absolute power in setting output prices. Their ability to set prices and realize profits depends on a whole host of conditions over which they don’t have control. My point is only that prices go up when corporations do have the ability to raise prices and realize higher profits.
Now that was a silly mistake, fortunately caught by careful readers.
The second graph above (which compared apples to oranges, the change in an index with a change in dollar amounts) should be replaced by the one below (with both series, of prices and wages, expressed in terms of percentage increases from a year ago).
Clearly, there’s a close—but by no means perfect—association between prices and wages in the U.S. economy.
But it is still the case that correlation is not causation. We still need a theory of price determination, and to include the role of profits. If price changes closely follow wage changes, then it can still be the case that corporations—in order to realize and protect profits—set output prices as a markup over costs (including wages).
What that means is that, when economists and pundits blame tight labor markets and subsequent wage increases for provoking inflation, they are choosing not to focus on the role of corporate profits.