Looking In The Right Places
The recent surge in commodity prices – notably oil but economy. It probably subtracted half a percentage definitely redistributed wealth across industries, including billions of dollars from airlines to oil producers. But a persistent rise in inflation is not among its outcomes.
In fact, history provides scant evidence of a linkage between commodity prices and inflation, aside from the price of commodities themselves. Comparing a “core” inflation measure preferred by Federal Reserve officials (the deflator for personal consumption expenditures, excluding food and energy) with a broadly based index of commodity prices (from the Commodity Research Bureau) yields a dismally weak correlation over the past 45 years. Tinkering with lags and focusing on sub-intervals – such as the 1970s – helps a bit, but the overall track record is still quite poor. Since the start of the 1990s, the relationship has actually been inverse, meaning that rising commodity prices tend to coincide with, and precede, declines in core inflation.
One explanation for the deterioration of this once weak, and increasingly insignificant, relationship is that central bankers have learned to read the signals of incipient price pressures and tighten policy accordingly, thereby preventing any pass-through to other prices. Another explanation emphasizes the diminishing role commodities play in our economy. In 1948, for example, goods accounted for 68 percent of consumer spending, but now that figure is down to 40 percent.
Regardless of the explanation, another indicator has proven far more reliable as an inflation predictor: unit labor costs. Defined as the labor-related cost to produce a given unit of output, this metric has demonstrated a far tighter, positive relationship with core inflation. Moreover, it is easier to predict over the course of the business cycle.
In the aftermath of a recession, for example, unit labor costs routinely slow down or decline. One reason is that the elevated unemployment rate weakens the negotiating position of labor, and compensation increases slow as a result. A second reason has to do with labor productivity, which typically posts its best gains during the first years of an economic expansion. With the profit squeeze of the recession still a fresh memory, and uncertainty regarding the outlook greater than usual, employers are usually slow to resume hiring even after output gains have initially picked up. And with output rising faster than employment, labor productivity accelerates. Taken together, the combination of depressed compensation gains and rising labor productivity keeps unit labor costs low.
As the expansion matures, however, tightening labor markets shift negotiating power in the direction of workers, enabling them to press for larger compensation gains. At the same time, increased hiring tends to restore work effort to more normal levels, and labor productivity slows. Together, bigger compensation gains and smaller productivity gains cause unit labor costs to accelerate.
At this point, it’s difficult to say exactly how far we’ve progressed into this latter stage, but there’s no doubt we’re there. Accordingly, one should look to the labor market – not commodities – when judging inflation prospects.
