The Role of Cost-Push Inflation

When I studied economics in the early 1960s, cost-push vs demand-pull inflation were hot topics that became relevant later in helping to explain the 1970' experience with stagflation.  Cost-push inflation is worth reviewing as background to the current questions as to whether stagflation may be returning.  Inflation has risen lately as the economy has weakened; so are we likely to slip back into stagflation?  Based on my understanding of the analysis of cost-push inflation in the 1960s and the unique circumstances of the 1970s, I don't think stagflation is in our future.  

The wage/cost-push question in the 1960s was whether monopoly power exercised by strong unions in pushing wages up beyond productivity growth or by the government doing the same in raising the minimum wage would cause inflation to rise.  Another way the question was put by one of my professors was whether labor unions could raise real wages in the long run.  That professor hired me as his test grader, and he always had a cost-push question on his final exam. 

In coaching me on how to grade answers to that question, he emphasized that a good answer had to contain at least two important elements.  The first was that, for wage-push to be inflationary, wages had to be pushed up by more than the increase in labor productivity.   Otherwise, the higher wages wouldn't raise unit labor cost; rising demand for labor would keep up with the artificial wage.  If out-sized wage increases — say, 10 percent — did push up unit labor costs, the second element of a correct answer had to do with the stance of monetary policy at the time. If monetary policy remained restrictive, the higher unit labor cost would cause employers to cut back on workers and rising unemployment would be the primary result.  Monetary policy had to ease enough to increase the derived demand for labor so that the supply and demand curves for labor would intersect at the higher mandated wage.  If that happened, monetary expansion would validate the higher wages, and, ultimately result in higher prices, or inflation. 

My professor summed all this up in a little poem that I still remember:  

Economists, all or most of us consent

If wage rates rise by 10 percent

It puts the choice before the nation

Of unemployment or inflation.  

Fed Policy in the 1970s  

During the 1960s and 1970s, Milton Friedman convinced most right-thinking economists that inflation was caused by too much money chasing too few goods and that inflation was always and everywhere a monetary phenomenon. Cost-push eventually came to be regarded as a secondary issue since its impact depended on monetary policy. Just keep the money supply growing at a rate comparable to the potential growth rate of the economy, and inflation should not rise.  The Fed could slip up if it took its eye off money growth and started targeting interest rates, or if it took its eye off inflation and started targeting growth or unemployment. It did.

Interest-rate targeting runs the risk of having the Fed inadvertently subordinate monetary policy to fiscal policy, when, for example, a growing budget deficit puts upward pressure on interest rates and triggers Fed ease to keep interest rates from rising.  Similarly, if some monopoly power pushes wages up, the resulting incipient unemployment could cause the Fed to inflate in its effort to maintain full employment.  So, the rule was to focus on money growth rather than interest rates and inflation rather than unemployment.

At about the same time, Milton Friedman convinced most economists that the Philips-curve trade-off between inflation and unemployment was bogus, at least in the long run.  That rationale meant that focusing on inflation and ignoring the adverse impact of inflation-fighting on unemployment was not a cruel policy.  Less inflation didn't necessarily mean more unemployment, at least not for long.

While monetarism grew in theory and in support by monetary economists, it didn't become a formal policy of the Fed until October 1979, when Chairman Volcker called a Saturday meeting of the FOMC and announced that henceforth the FOMC would focus exclusively on money growth and ignore its impact on interest rates.  Prior to that, during the 1970s, the FOMC had recognized the importance of money growth, but their operating procedures involved estimating what short-term interest rates would be consistent with the correct rates of money growth and they would try to hit their money-growth target indirectly by hitting their Fed funds target.  It turned out however that they consistently underestimated the level of interest rates that would be necessary to slow money growth to noninflationary rates. The degree of their underestimate became obvious when rates were turned loose and rose far above expected levels, with some rates over 20 percent for a time.

The shift in procedure to direct money targeting caused Fed watchers to focus as closely on the money supply statistics as they now do on the target Fed Funds rates.  The new monetarist approach to monetary policy gradually faded away in the 1980s as financial innovation and deregulation made difficult the question of the appropriate definition of money and loosened the link between the money supply, however defined, and economic activity.  The more sophisticated economists — especially those from universities that didn't have good football teams — described the problem as the demand for money becoming unpredictable and unstable. Being from a jock school, I described it more simply as an unpredictable or unstable velocity of money. 

In any case, the Fed went back to Fed-funds targeting while glancing only occasionally at the money supply.  It seemed ironic when I served on the FOMC that most members still believed that money matters most and that inflation was ultimately a monetary phenomenon but paid less and less attention to money and rarely talked about it in public or privately for that matter.  Nevertheless, Fed-funds targeting worked out pretty well as inflation declined to the point of causing some concern about possible deflation.  The FOMC hasn't made the same mistake in operating procedures that it made in the 1970s, at least, not yet. 

Special Circumstances in the 1970s

I have focused at length on the issue of cost-push or wage-push inflation and the Fed's faulty operating procedures because I believe both to be important contributors to the stagflation of the 1970s.  The Fed inadvertently contributed to inflation through rapid monetary expansion while sticky wages and costs kept unemployment from falling as inflation later receded.  I believe the relative absence of downward wage flexibility to be a primary cause of stagflation of the 1970s and their greater flexibility today to be the primary reason we will dodge that bullet in coming years.  A huge turning point in that regard was President Reagan's firing of the air traffic controllers in 1981, which accelerated the decline in union monopoly power, i.e. the power to push wages up without increases in productivity.

Another significant difference between now and the 1970s is the difference in productivity growth.  Productivity growth in the 1970s was anemic compared to its growth since the mid 1990s.  In rough, round numbers, it was less that 1.5 percent in the 1970s and close to 3 percent since the mid-1990s. As the new economy period demonstrated, faster productivity growth means that wages can rise faster without exceeding productivity growth, leaving unit labor cost and inflation relatively flat. Rapid productivity growth continued into the 2000s, but has fallen off some in the last couple of years, the surge in the third quarter of 2007 notwithstanding. 

Productivity growth, in addition to depressing unit labor cost despite rising wages, gives the Federal Reserve more leeway to allow high growth rates in the economy without so much concern about inflation.  Some call that higher potential growth rate of the economy a higher speed limit for the Fed to enforce. The FOMC's recent projections out to 2010 implies that they are pessimistic regarding an acceleration of productivity growth.

Another difference in the two decades is all the deregulation that makes our economy more flexible and resilient since the mid-1990s didn't start until the late 1970s. The deregulation of many industries, but particularly banking and finance, has added to flexibility and has made the economy much more resilient.

In contrast to today's resilience, consider the impact of the Arab oil embargo, in October 1973 and its impact on the economy.  Pushing up oil prices by restricting supply has both an inflationary effect on the total economy (depending on monetary policy) and a depressive effect on the non-energy sectors of the economy.  The first oil embargo had a large impact because earlier cheap oil and energy had left the U.S. economy energy inefficient, in contrast to much greater energy efficiency today, which has allowed us to tolerate (so far) current record energy prices.  Another big difference is that today's high energy prices result from booming demand rather than supply restrictions.  You don't get stagflation from demand pull as you might from cost push.

Another major difference (I hope) is that we are unlikely to repeat the mistake President Nixon made in imposing wage and price controls in August 1971, which distorted the price mechanism for a couple of years and caused a misallocation of resources.

Conclusion

To summarize, in 2008 we have greater wage- and price-flexibility than in the 1970s, fewer cost- and wage-push forces, more deregulation, a wizened Fed, more energy efficiency, and, not mentioned earlier, more globalization imposing price and wage discipline.

While inflation has crept up to uncomfortable levels and the real economy slowed in the 4th quarter, I doubt that stagflation in any serious way is in the cards.  Given the differences I've cited above, that's more than just a hope and a hunch.  But it's that too.

Bob spoke with Bloomberg's Tom Keene about the Fed's decision to lower its benchmark interest rate by half a percentage point to 3 percent, the risk of a U.S. recession and the outlook for the credit default swaps market. To listen to the interview, click here.

Today is the 49th anniversary of the day the music died, when a plane crashed in a snow storm killing Buddy Holly, Richie Valens, the Big Bopper, and the pilot. As band member Sonny Curtis later put it, "That'll be the day" came way too soon." Waylon Jennings wasn't on the plane because he "lost" a coin toss, reminding us all that we never really know when news is good or bad. I was a high school junior in 1959, and, of course, I liked Buddy, but those were the days of Elvis, Chuck Berry, Jerry Lee Lewis, and so forth. Elvis was king.

Many years later my appreciation of Buddy grew when I was in London and went to the play, Buddy, which had been running for years.  I wouldn't have thought a play in London could capture the austerity of a small radio station in Lubbock, Texas, but it did.  But, more than that, when the play ended, the reserved British were dancing in the aisles of the theater.  Buddy ballooned in my estimation that night.

Some time later I was going to Lubbock to make a speech, and I asked someone to drive me by the cemetery that contained Buddy's grave.  I had my picture made there, leaving guitar picks as was the custom, and later included that picture in my President's Letter in the Dallas Fed's annual report, alongside a picture of me at Adam Smith's grave in Edinburgh, Scotland.  I thought those two heroes gave me balance.

Gary Bussey played Buddy wonderfully in a pretty good movie.  My favorite scene was when Buddy and the Crickets went to New York to sign a recording contract.  The host offered champagne for the occasion when Buddy said, "Make mine a coke," and one of the others said, "Make mine a Dr. Pepper."  They were Texans all right.  While I liked the movie a lot, it apparently contained some flaws that mattered to some people, like mountains in the background of Lubbock.  To set the record straight, Paul McCartney produced and hosted The Real Buddy Holly Story, a documentary that included great footage and much reminiscing by Buddy's former band members, music producers and others.

You probably already know that the Beatles took their name from the Crickets, but there were more connections than that.  Buddy had the first solid guitar they had seen with a gear shift on the side. He was one of the first performers to write and perform his songs; up until then you had your song writers and your singers.  This inspired the Beatles to write songs as well as perform, according to McCartney.  Buddy was also one of the first performers to wear his glasses while performing — black horn rims, no less.  His example is reported to have given John Lennon the courage to do the same.  There was more, but you get the point.

(Don't worry, I'll get to Greenspan later.)

National Public Radio thought it odd that a Reserve Bank President would put his picture at Buddy Holly's grave in his annual report letter. So, near the end of an interview about the economy, the host brought up the subject and asked if it was true that I had made a pilgrimage to Buddy Holly's grave.  I told him it was true.  He then asked me what Buddy Holly had contributed to the economy.  I told him that Buddy's Rave On would have made a great  anthem for the booming New Economy. That was a taping rather than a live interview.  It ran two days later when, using the marvelous ability NPR has with sound and sound effects, as the interview drew to a close, Rave On, started up softly then reached full crescendo as the program ended.  That was, without doubt, my finest hour.  I had brought Buddy Holly back to radio.

As you might imagine, Alan Greenspan showed some curiosity about the Buddy Holly thing and, in particular, the annual report picture at Buddy's and Adam Smith's grave. So, taking the offensive, I proposed that the Chairman and I co-author an essay about Buddy Holly and Adam Smith, the father of Rock and Roll and the father of Economics. The Chairman graciously declined my offer on the grounds that his taste in music was more like Adam Smith's taste than mine, i.e. J.S. Bach. I wrote back and told him I'd heard of old J.S., but I thought Buddy had more hits.

Rave On!