The writer is chief economist at UBS Global Wealth Management
In global financial markets, US Federal Reserve Chairman Jay Powell is increasingly playing the role of playground bully – threatening the prostrate shape of the global economy and chanting “hike, hike, hike” with malevolent joy. US policy rates are rising relentlessly.
However, Powell’s public remarks offer little insight into how he expects higher rates to keep inflation in check. The omission is important because the current policy tightening will have an impact in an unusual way. This is because today’s price inflation is more a product of profits than wages.
General inflation is normally a labor cost issue. The rule of thumb is that labor costs are about 70% of the price of consumer prices in a developed economy. If wage increases are not matched by greater efficiency or reductions in other costs, the consumer will pay a higher price for the labor he consumes. With normal inflation, central banks should create slack in labor markets to drive down wages.
Wages have risen, but prices have risen faster, so real wage growth is catastrophically negative. This is a far cry from the 1970s-style wage price spiral; apart from the wage and price control debacle under President Richard Nixon, real average wages in the United States rose for most of the decade.
The US restaurant and hospitality sector explains why labor costs have played a limited role in current inflation. Since the end of 2019, the average salary of a worker in this sector has increased by just under 20%. But the number of employees fell by more than 5%. Paying fewer people with more money means the sector’s payroll has increased by about 13%. The real output of the sector increased by 7 percent. So American restaurants and hotels are paying fewer people more money to work harder. The rise in labor costs adjusted for productivity since the end of 2019 is between 5 and 6%. Restaurant and hotel prices increased by 16%.
This is the story of current inflation. Businesses passed on the higher costs to customers. But they also took advantage of the circumstances to increase their profit margins. The widening of inflation beyond commodity prices corresponds more to an expansion of the profit margin than to pressures on labor costs.
How is it going ? Two forces have combined. Despite negative real wages, consumers continued to consume. Strong household balance sheets after the pandemic allowed for a decline in saving and an increase in borrowing to offset the dire real wage situation. The resulting resilience in demand has given businesses the confidence to raise prices faster than costs.
Moreover, the power of storytelling has conditioned consumers to accept price increases. Imagine the story of a farmer who brings wheat to the windmill, where it is ground into flour and then baked into bread. In this imaginary world, a 22% rise in the price of wheat, for example, could be used to justify a 15% rise in the price of bread.
An economist might sputter incoherently on his morning toast and point out that only 10-15% of the price of bread is attributable to the cost of wheat – the cost of food in developed economies is not about food at all; it’s labor costs. But the narrative may sound plausible to many consumers.
And consumers seem to buy stories that appear to justify price increases, but actually serve as a hedge for profit margin expansion. Indeed, the soundbite economy of the Twitter era facilitates this process.
This unconventional inflation means that rising unemployment and falling wages are not the only possible remedies. Politics has more ways to reduce inflation if the cause is a matter of profits. Of course, higher unemployment and lower wages would weaken demand and reduce profit margins.
But any slowdown in demand – for example by slowing the leverage of household balance sheets – would also affect pricing power. The slowdown in demand for durable consumer goods this year has turned the fastest price inflation on record for these products into the most dramatic deflation since data collection on them began in the 1950s.
So the prices that fueled the inflation story at the start of 2021 were transitory after all. Understanding this, the narrative used to justify today’s higher prices could also come under attack. Social media memes work both ways; a “scam in Britain” narrative and intense media concentration in the UK in 2010 may have dampened inflation at that time. Ending Fed Chairman Powell’s sphinx-like silence on what higher rates are supposed to accomplish could help turn the tide on inflation.
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