Conflated Issues Inflated Fears

Inflation chart cause

There’s fear, right here in the outback, that raising the minimum wage will drive up inflation.  The Humboldt Sun (Sept. 18, 2015 p3)  includes a long LTE titled, “$15 minimum wage would stimulate inflation.”   The author writes:

“The government requires businesses to pay employees more by passing minimum wage legislation. This increase is not because workers are more productive, so it costs more to produce goods and services. Businesses might lay off workers to bring down labor costs, but that results in less output. Ultimately, they must raise the cost of consumer goods.”

Conflation

There are several macro-economic concepts mashed into this, but let’s assume that the writer is speaking of the form of inflation diagrammed in Chart 2 above, “Cost-Push Inflation,”  defined as follows:

Cost-push inflation … occurs when prices of production process inputs increase. Rapid wage increases or rising raw material prices are common causes of this type of inflation. The sharp rise in the price of imported oil during the 1970s provides a typical example of cost-push inflation (illustrated in Chart 2). Rising energy prices caused the cost of producing and transporting goods to rise. Higher production costs led to a decrease in aggregate supply (from S0 to S1) and an increase in the overall price level because the equilibrium point moved from point Z to point Y. [SFFRB]

Cost-Push inflation might be presented as the Inflation Monster, IF it were the only kind of inflation possible – it isn’t.  There’s also Demand-Pull.  And we return to the San Francisco Federal Reserve for its basic definition:

“Demand-pull inflation occurs when aggregate demand for goods and services in an economy rises more rapidly than an economy’s productive capacity. One potential shock to aggregate demand might come from a central bank that rapidly increases the supply of money. See Chart 1 for an illustration of what will likely happen as a result of this shock. The increase in money in the economy will increase demand for goods and services from D0 to D1. In the short run, businesses cannot significantly increase production and supply (S) remains constant. The economy’s equilibrium moves from point A to point B and prices will tend to rise, resulting in inflation. [SFFRB]

And how does a central bank increase the supply of money? Monetary policy.  The textbook way, prior to September 2008, was that if the opportunity costs for holding noninterest-bearing bank reserves was the nominal short-term interest rate (federal funds rate), then we’d have a situation in which if the funds rate were low the quantity of reserves banks would want to hold would increase. [SFFed]  Note: the banks have an interest in putting reserves to work by lending them.  If a bank found itself with “excess” reserves the obvious thing to do would be to find borrowers and earn a return on the money. Thus the situation wherein the cost to the banks of borrowing money is essentially zero, in a post 2007-08 effort to support the financial markets and kick-start the economy.  Now what?

Why hasn’t there been some awesome Demand-Pull Inflation?  Monetary Policy. The situation has changed, although few outside the financial commentators have paid much notice.

“The change is that the Fed now pays interest on reserves. The opportunity cost of holding reserves is now the difference between the federal funds rate and the interest rate on reserves. The Fed will likely raise the interest rate on reserves as it raises the target federal funds rate (see Board of Governors 2011). Therefore, for banks, reserves at the Fed are close substitutes for Treasury bills in terms of return and safety. A Fed exchange of bank reserves that pay interest for a T-bill that carries a very similar interest rate has virtually no effect on the economy. Instead, what matters for the economy is the level of interest rates, which are affected by monetary policy.” [SFFed]

If Demand-Pull inflation is corralled by monetary policy which is based on the Federal Reserve now paying interest on reserves, doesn’t this argue against raising wages which will increase unit costs of production and hence raise consumer prices?  Not necessarily.

The author of the LTE maintains: “The Federal Reserve has held interest rates at near 0 percent for several years. Some claimed cheap loans would stimulate the economy. The problem is that banks have been fiscally conservative, with few loans and little interest rate to savers.”

A crucial part of this puzzle is the press release from October 6, 2008 from the Federal Reserve stating:

“The Federal Reserve Board on Monday announced that it will begin to pay interest on depository institutions’ required and excess reserve balances. The payment of interest on excess reserve balances will give the Federal Reserve greater scope to use its lending programs to address conditions in credit markets while also maintaining the federal funds rate close to the target established by the Federal Open Market Committee.”

Yes, the interest rate remained low, but the banks with excess reserves on hand had less incentive to loan out those reserves if they could simply leave them on the books and earn interest.  The Financial Services Regulatory Relief Act of 2006 allowing this situation  [S 2856 109th] was quite generous to the bankers, such as section 201 which “(1) authorize payment of interest on funds maintained by a depository institution at a Federal Reserve bank; and (2) authorize the Federal Reserve Board to reduce to 0% the reserves required to be maintained by a depository institution against its transaction accounts. (The current requirement ranges from 3% to 14%.)” [GovTrack]

While the Federal Reserve makes a nice scapegoat for those who believe in broader extensions of consumer credit, it really doesn’t do to belabor its role (or lack thereof) in stimulating the consumer end of the economy when Congress provided the vehicle by which the wall between brokers and bankers was breached (Title 1, Section 101) and compounded the issue by enacting authorization for banks to sit on reserves in order to earn interest (Title 2, Section 202).

And, here’s where the LTE author swims in shark territory – a monetary policy which encourages broader consumer lending would also be a factor in the creation of Demand-Push inflationary pressures.  A person really can’t have it both ways.

How much is too much?

There are, in both fact and theory TWO forms of inflation.  Nor can we assume that inflation is always a bad thing.  Most economists like an inflation rate of just under 3%. [Investopedia]  Why? Because the alternative – deflation —  is even worse.  During deflationary periods workers get laid off, consumers spend less, people hold off major purchases believing prices will fall further, and the spiral continues – downward.

Consumer Price Index 2005 to 2015 The blue line includes items like energy/food which are inherently more volatile, the line for all others shows a fairly consistent rate of inflation right around the 2.5% mark – remember 3% is the economist’s ideal. It’s also useful to note that the wide variances occur between January 2008 and January 2010 – when the U.S. economy was trembling before and  in the wake of the financial crash.

Consumer Price Index chart If fact, before we become too alarmed by inflationary trends we might want to take a look at the column highlighted above from the Bureau of Labor Statistics, and note that we are well below that 3% threshold.  In other words, it’s time to stop worrying excessively about inflation – both forms – and start being concerned with why wages and salaries have tended to stagnate over the past thirty years?  [Pew]

“…after adjusting for inflation, today’s average hourly wage has just about the same purchasing power as it did in 1979, following a long slide in the 1980s and early 1990s and bumpy, inconsistent growth since then. In fact, in real terms the average wage peaked more than 40 years ago: The $4.03-an-hour rate recorded in January 1973 has the same purchasing power as $22.41 would today.” [Pew] see also: [EPI]

Our local author is still alarmed, “Recent price spikes are more noticeable than the usual gradual increases.  That naturally leads to call for a minimum wage increase. But if granted, the inflation cycle will begin again.”  To which we’d have to ask:

  • What recent price spikes? The annual inflation rate as calculated by the BLS Consumer Price Index, the figures the economists use, has been less than 2.5% since 2006.  Further, the prices of gasoline has dropped from about $4.11 in July 2008 to $2.73 as of August 2015. [EIA]
  • If not those phantom price spikes, then what else could raise the call for an increase in the minimum wage?  The trends in stagnant wages and salaries?
  • What inflation cycle?  The annual increase in inflation hasn’t risen above 2.5% since 2006 and 3% is the threshold used by most economists to determine a “significant” increase.  During five of the last ten years we’ve experienced inflation of less than 2%.
  • However, let’s not assume that the author is referring to the here and now but to the ubiquitous “awfulness to come somewhere down the road about which we should be terribly alarmed.”  Is there anything in the statistical tables indicating that an increase in the federal minimum wage would yield inflation rates in excess of traditionally  held economic standards?  Given that the federal minimum wage has been raised 22 times since first authorized in 1938, has there been any drop in the real GDP per capita in the last 75 years? (Hint: no)

If it’s not consumer spending driving an inflation cycle in the modern economic environment – what is?  There is something about which we ought to be worried, but it’s not your father’s inflation cycle – it’s the climate created by the financialists:

“Both gross and net business debt have continued to rise since 2007, but the proceeds have been almost entirely recycled into financial engineering—including more than $2 trillion of stock buybacks and many trillions more of basically pointless M&A deals.

This diversion of the $2 trillion gain in business debt outstanding since 2007 to financial engineering is owing to the near zero after-tax cost of corporate debt. The latter has caused the enslavement of the C-suite to the instant gratification of rising share prices and stock options value in the Fed’s Wall Street casino.” [ZeroHedge]

Not to put too fine a point to it, but the brakes will be applied to any inflationary pressure by the bursting of the next financial bubble.

References and Sources: Federal Reserve Bank of San Francisco, “What are some of the factors that contribute to a rise in inflation?’ October 2002.  John C. Williams, “Economic Research: Monetary Policy, Money, and Inflation,” Federal Reserve Bank of San Francisco, Economic Letters, July 9, 2012.  Bernard Shull, “The impact of financial reform on Federal Reserve Autonomy,” Levy Economics Institute of Bard College, working paper 735, November 2012. (pdf)  Douglas Rice, “Inflation: It’s a Good Thing,” Investopedia, May 22, 2009.  Bureau of Labor Statistics: Consumer Price Index, 12 month percentage change. (2015) “For most workers wages have barely budged for decades,” Pew Research Center, October 9, 2014.  EPI, wage stagnation in nine charts, January 6, 2015.  CBPP, “A guide to statistics on historical trends in Income Inequality,” revised July 15, 2015.  L.E. Hoglund, “Gasoline prices: cyclical trends and market developments,” Beyond the Numbers, BLS, May 2015. (pdf) EIA, “Petroleum and Other Liquids: Retail Prices all grades and formulations, August 2015.  Department of Labor, “Minimum Wage Mythbusters.”  CNN, “Minimum wage since 1938,” interactive graphic.  “Meet the New Recession Cycle,” Zero Hedge, April 4, 2015.

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