Wages/Prices

Tight Labor market/No Inflation


There seems to be a mystery in the higher realms of economics--especially the Fed. The labor market is tight, so why there is no inflation?

Some policymakers cite the increased ease with which shoppers can compare prices on the internet and the impact these changes have on brand loyalty and pricing power. Amazon is entering grocery retail via Whole Foods, while the hotel sector is being overturned by Airbnb. But if inflation were held down by rising aggregate supply, then you'd expect rapid GDP growth. Instead we have the opposite.

This is Caroline Baum from MarketWatch:

Almost every discussion on this subject begins with a statement of fact that the tight labor market, as evidenced by the 4.4% unemployment rate, should be lifting wages and prices.
Note the order: wages and prices. A tight labor market leads to higher wages, which lead to higher prices. This is one of those myths that never dies: cost-push inflation. Milton Friedman was adamant that both prices and costs rise in response to an increase in aggregate demand, which is a function of the Fed's money creation. Wage and price increases are a reflection of inflation, not a cause of it.
As to the relationship between prices and wages, they generally move together. But prices lead wages, not the other way around. You can read about the relationship in academic literature, or you can think about how businesses operate.
Let's start with a small-business owner whose company produces widgets. He begins to see a pickup in sales. Pretty soon, his products are flying off the shelf, and he can't accommodate the increased demand.
What does he do? A rational businessman raises his prices to allocate the limited supply. If he still can't satisfy the demand for widgets, he may try to increase output using his existing staff, paying overtime if necessary. If he still can't meet his customers' demand for widgets at the higher price, he will most likely look to add staff.
In the mythical cost-push-inflation world, a businessman responds to increased demand by paying a higher wage to attract additional workers -- and then tries to raise prices to preserve his profit margins.
Which of those examples describes how businesses operate? Good. Let's move on.