Some Economists Question Link Between Wages and Inflation

It’s long been an article of faith among influential people on Wall Street and at the Federal Reserve that widespread pay raises are inflationary and, thus, bad news. But now some academic researchers and even Wall Street economists are saying, in essence, it’s time for ordinary workers to get a break and for the investment world to stop thinking like Scrooge.

Moderately higher wage increases, the argument goes, might even perk up the economy--not to mention give the average worker hundreds of extra dollars to spend.

The recent sputtering of the national economy, which prodded the Fed this month to cut short-term interest rates, has eased analysts’ concerns about the potential for wage-driven inflation in the near future.

But some of the economists who scold Wall Street and the Fed for worrying too much over the years about the American public’s pay increases say their grievance strikes at a more fundamental issue: They contend that ideas that have governed much of the investment world’s thinking on inflation have been proved wrong.

For decades, the fear of wage-driven inflation has flowed from a concept known as NAIRU, the acronym for non-accelerating inflation rate of unemployment. In a nutshell, the idea holds that inflation is triggered when joblessness falls below a threshold considered the “natural rate of unemployment.”

According to this theory, the trouble begins when the labor market becomes so tight that employers must aggressively boost wages to attract and keep workers. In turn, those higher labor costs either cut employers’ profits or are passed along to customers in the form of higher prices.

That’s why nearly every time a government report shows workers getting bigger wage increases, you can count on stock prices falling. And speculation usually begins that the Fed will act to prevent dreaded inflation and stop the economy from overheating.

These days, analysts’ main concern is the slowing U.S. economy. All the same, the recent report that average hourly earnings rose an unexpectedly high 5 cents last month contributed to a stock market plunge.

Since the mid-1980s, economists have widely considered the “natural rate” of unemployment to be 6% or even higher. Many clung to that position long after the jobless rate fell below 6% in September 1994. These economists have explained away the subsequent lack of inflation by arguing that, essentially, the United States lucked out because such factors as economic weakness overseas brought us cheap imports that prevented price increases in this country.

But unemployment has been below 4.5% for two years, and currently stands at 4%, without evidence of substantial inflation. So economists increasingly are questioning the natural rate theory.

“The unemployment-inflation relationship has obviously broken down in the last few years,” said James Stock, a Harvard economist who has studied the link between inflation and other economic measures.

Lee Ohanian, a UCLA economist and inflation expert who also is skeptical of the natural rate theory, contends, “Professional forecasters have been looking for higher inflation year after year, and it just doesn’t reappear. . . . The inflation-scare guys have been crying wolf so long that the burden of proof is on them.”

Giving workers healthy raises wasn’t always considered an oddball idea or a harbinger of inflation in the business community. Auto industry pioneer Henry Ford in 1914 raised the minimum wage for his employees to $5 a day, more than twice what most wage earners received.

The basic intent was to set a pattern of wages throughout the economy that would provide average workers with enough money to buy the kinds of goods they were making in their own factories. Union advocates and others sympathetic to worker causes say Ford’s logic still makes sense.

As recently as the 1960s, unions were strong enough to command wages for large numbers of workers that kept up with, or exceeded, increases in the cost of living--and the reaction on Wall Street was milder than it is today. Dean Baker, an economist who reviewed economic news coverage of that period, said, “There was none of this ‘Oh no, unemployment is too low, so workers will get wage gains.’ It was a very different attitude from what you have today.”

Part of the reason for the change in attitude was the nation’s encounter with stagflation, simultaneous slow growth and inflation, in the 1970s. But many say the natural rate of unemployment idea dates to 1967, when Nobel laureate economist Milton Friedman described the concept at a meeting of the American Economics Assn.

Although initially an explosive idea, it became a fundamental part of economic thinking. Even today, critics who question restrictive Fed policies tend to see some merit in Friedman’s concept.

Stock, the Harvard economist, contends that inflation is indeed linked to the overall level of activity in the economy. But he says the unemployment rate no longer is a good gauge of the overall economy’s activity. Instead, he looks at such indicators as plant utilization, which still is nowhere near capacity.

Other critics say that a natural rate of unemployment does, in fact, exist. But they say it is lower than believed because of technology-driven changes in the economy that are linked to sharp gains in productivity. Some of these critics estimate that the natural rate is around 4.5%.

Although Wall Street and the Fed don’t directly set workers’ pay, the critics say exaggerated concerns about low unemployment and rising wages kindling inflation may have prodded the central bank to act too aggressively to slow down the economy. From mid-1999 to mid-2000, the Fed raised interest rates six times. That, in turn, could mean fewer jobs and smaller paychecks in the coming year.

Critics may quibble with Fed policy, but their frustration isn’t always directed at Fed Chairman Alan Greenspan. He is seen as much less wedded to the natural rate idea than other Fed governors.

Long before the U.S. economy started to cool, many Fed watchers began to count Greenspan among those who had grown less worried about low rates of unemployment triggering higher inflation. They cite Greenspan’s willingness to let joblessness fall below 4.5% before starting to raise interest rates in mid-1999. And, this month, Greenspan apparently was the driving force behind the Fed interest rate cuts that were intended to reinvigorate the economy.

In addition, Fed watchers point to Greenspan’s repeated declarations that worker productivity has grown due to structural improvements in the economy, rather than because of temporary factors that could disappear.

It’s a basic principle of economics that increases in productivity--essentially, the level of output per worker every hour--enable companies to pay workers more without having to raise their prices to customers. Productivity gains are widely credited with powering, since the mid-1990s, a vibrant national economy that brought low unemployment, low inflation and, for the first time in decades, real wage increases--that is, wage increases exceeding rises in consumer prices.

These days, with the national economy slowing again, some analysts say wage increases that are in line with the continuing productivity increases could spur the economy by stimulating consumer spending. When workers are more productive, “you want real wages to rise,” said Mickey D. Levy, chief economist at Bank of America and a critic of the natural rate idea.

Such critics note that a variety of measures show that over the last 10 years, pay and overall compensation have risen more slowly than productivity. Conservative measures put that gap between compensation and productivity growth at about 2.5%.

That suggests average wages for U.S. production workers, currently $14.01 an hour, could have grown about 35 cents more, to $14.36, without risking harmful inflation. For an average production employee working 40 hours a week, that would mean about $725 more a year, before taxes. Others estimate that the amount of money could be more than double that sum, based on different measures of the gap between pay and productivity trends.

So why do the majority of macroeconomists cling to the basic idea of a natural rate of unemployment? “Old notions die hard, even when they’ve been proven wrong time and time again,” Levy said. “The whole notion that strong growth and low unemployment necessarily drive up inflation is ingrained in financial markets.”

On the other hand, Marvin Kosters, director of economic policy studies at the conservative American Enterprise Institute, defends the theory as a tool for analyzing the economy. “It doesn’t tell you everything you want to know, but it’s a useful framework, and there’s nothing really to replace it,” Kosters said.

The key advocate of the natural rate theory at the Federal Reserve is Fed governor Laurence H. Meyer, the central bank’s most vocal anti-inflation hawk. Meyer has repeatedly sounded the alarm about the potential for a tight labor market to translate into inflation.

Although Meyer was quoted early last year as saying that the natural rate of unemployment is lower than it once was thought to be, in November he warned that the economy may be heading into a transition characterized by “slower growth and perhaps also higher core inflation.”

Most economists, to be sure, laud the Fed for its anti-inflation vigilance in recent years, and note that the nation has enjoyed a record-long expansion without inflation. Kosters, of the conservative American Enterprise Institute, acknowledged that workers would fare better in the short run if the Fed relaxed its inflation-fighting policies, as some liberal economists have proposed. But, Kosters added, “It’s clear that that’s not the answer.”

The nation’s spells of stagflation in the 1970s and 1980s, he said, show that over the longer run, the era of looser Fed policy “was a disaster in terms of productivity growth and real income growth.”

“Of course, the average guy and the average worker should get a break,” Kosters said. “But his break, when it comes down to it, is dependent on how much he can produce.”