Worrisome Inflation News

Today's Washington Post reports some news that can only be viewed as worrisome for the inflation picture:

Wages and benefits rose strongly in the spring, the government reported yesterday, providing a bit of good news for some workers -- and fresh concern about inflation. The statistic known as labor compensation, which includes wages and employment benefits, rose at a robust 6.6 percent annual rate from April to June, the Labor Department said....

"We're seeing a labor market that is tighter and beginning to manifest itself in higher wage inflation, which is probably going to get worse before it gets better," said one of the paid worriers, Nariman Behravesh, chief economist at Global Insight Inc., a financial analysis and forecasting firm.

(I quote this excerpt in part because Nariman was once my boss--in the summer of 1978, when I was a student intern in the macro group at the Congressional Budget Office.) The Post also reports on the Fed's "Beige Book" survey:

the Fed survey also echoed the Labor Department's report, as some of the 12 Federal Reserve Bank districts reported "sharp wage increases or wage pressures" for workers in certain industries, such as information technology, trucking, retail, finance and health care. The Fed survey showed shortages of certain high-skilled workers.

It might be worth reviewing the ec 10 logic for how wages (broadly measured, including benefits) translate into prices. The starting point is:

Price = Markup x Marginal Cost.

where the Markup reflects how much the market deviates from the ideal of perfect competition. The marginal cost of producing an extra unit of output equals the cost of hiring an extra unit of labor divided by the marginal productivity of labor, so

Price = Markup x Wage/(Marginal Product of Labor).

Wage inflation of 6.6 percent is likely to translate into significant price inflation unless (1) the economy become increasingly competitive, so markups fall, or (2) productivity rises at an exceptional pace. Either outcome is possible, but it is a better bet that if wage inflation continues at this pace, a troubling amount of price inflation will not be far behind.

Here is the dilemma for monetary policy: If the economy slows, as recent signs from autos and housing suggest, and inflation rises, as these labor market data suggest, what is the Fed to do? Remember that there are two terms in the Taylor rule. The Fed should lower interest rates in response to a slowing economy and raise interest rates in response to rising inflation. No one knows the Bernanke Fed's preferred coefficients on these two terms (now that would be real transparency!). We may soon start to find out.