Inflation and your investments: Wages and Inflation

The growth in wages is closely related to the behavior of the business cycle. As the economy strengthens, the growth in wages tends to increase as unemployment declines. As unemployment declines, confirming a strong economy, the tighter the labor market becomes, the more pressure there is on wages to rise. A slowdown in the economy close to or below the long-term average of 2-1/2 to 3 percent, creates an increase in the unemployment rate; and with more availability of workers, growth in wages is likely to stabilize or decline.

The growth in wages has the same turning points as inflation as inflation because its behavior is that of a lagging indicator. The outcome is that turning points in wages follow turning points in coincident indicators both at troughs and at peaks of the business cycle.

The process can also be visualized as follows:
• A peak in the growth of the money supply is followed by
• A peak in the growth of the economy and employment, which is followed by
• A peak in the growth of wages, which is followed by
• A trough in the growth of the money supply, which is followed by
• A trough in the growth of the economy and employment, which is followed by
• A trough in the growth in wages, which is followed by
• A peak in the growth of the money supply
And the cycle starts over again.

Because of the cyclical relationship between wages and inflation, it is generally believed that a tight labor market, a strong economy, and rising wages are inflationary. There is not necessarily a relationship between wages and inflation. In other words, growth in wages may not be inflationary.

In the 1960s and the 1980s the US economy experienced strong growth in wages but very low inflation. In fact, in the 1990s wages were growing at three to four percent, while inflation was close to two percent. In spite of this evidence, policymakers, including some members of the Federal Reserves systems, believed in the Phillips Curve. The Phillips Curve relates the simple fact that a higher unemployment rate is associated with lower inflation and a lower unemployment rate is associated with higher inflation. The policymakers' conclusion is - let's not let the unemployment rate fall too far down, otherwise that could be a signal that inflation will start rising due to higher wages. Again, this is a fallacy because the facts have shown quite clearly that wages in the 1960s and the 1990s were rising faster than inflation and inflation remained under control. The only thing that the Phillips Curve shows is the obvious truth that as employment growth declines, wages accelerate. However, the experience of the 1960s and the 1990s shows quite clearly that an increase in the growth in wages is not necessarily inflationary.

So how is this dilemma solved? The dilemma is solved by looking again at real short-term interest rates. High real short-term interest rates increase the cost of borrowing and business is forced to invest in higher rate of return projects. Consumers on the other hand are also discouraged from overspending due to the higher cost of borrowing.

Let's look at it from a business viewpoint. The higher cost of borrowing forces businessmen to invest in projects that have a higher rate of return. But higher rate of return projects are usually projects with a high technology content, higher rates of return, and higher productivity. This is what is the missing link - productivity growth. High real short-term interest rates force businesses to be efficient and therefore increase their productivity. As productivity increases, the higher growth of productivity allows business to absorb the higher increase in wages. For instance, if wages are increasing at four percent, and productivity is also increasing at four percent, the unit labor cost to business is zero.

Wages are not the elements that create inflation. The element that creates inflation is low productivity growth. However, with high real short-term interest rates, by keeping prices down, by keeping the inflationary process low, it forces business to improve productivity. Since business cannot raise prices in a period of low inflation, they have to improve productivity to improve efficiency and improve margins. Wages are not inflationary unless productivity slows down dramatically. But this can only happen in an environment of very easy monetary policy with very low real short-term interest rates at or below the inflation rate. For instance, although in 1999 workers compensation was rising at a very strong 5.2% pace because of a very strong manufacturing sector, unit labor costs, that is labor cost-adjusted for productivity, were actually down 1.7% because of strong productivity growth of 6.9% in the manufacturing sector.

Investors should look at the trend of unit labor cost which is a quarterly release by the Bureau of Labor Statistics that ties productivity to workers compensation and also shows the unit labor cost index. Unit labor costs are also lagging indicators. Unit labor costs typically tend to rise after the economy is growing very rapidly, is in the upswing and slows down following a slow down in the economy. However, if - and this is a very important point - real short-term interest rates remain high, one should not expect a strong rise in unit labor costs - if any at all. The main reason is that high real short-term interest rates keep inflation low. As a result, business cannot raise prices. In order to improve profitability, corporations have to increase productivity, which keeps labor costs down. We will see later how this information regarding trends in commodities, trends in unit labor costs, and trends in inflationary pressures impact decisions concerning investment in bonds.

(From Chapter 7 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China. The book is available at Amazon.com).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

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