Labor Market Conditions Index Discontinued

A few years ago, I blogged about the Fed's new Labor Market Conditions Index (LMCI). The index attempts to summarize the state of the labor market using a statistical technique that captures the primary common variation from 19 labor market indicators. I was skeptical about the usefulness of the LMCI for a few reasons. And as it turns out, the LMCI is now discontinued as of August 3.

The discontinuation is newsworthy because the LMCI was cited in policy discussions at the Fed, even by Janet Yellen. The index became high-profile enough that I was even interviewed about it on NPR's Marketplace.

One issue that I noted with the index in my blog was the following:

A minor quibble with the index is its inclusion of wages in the list of indicators. This introduces endogeneity that makes it unsuitable for use in Phillips Curve-type estimations of the relationship between labor market conditions and wages or inflation. In other words, we can't attempt to estimate how wages depend on labor market tightness if our measure of labor market tightness already depends on wages by construction.

This corresponds to one reason that is provided for the discontinuation of the index: "including average hourly earnings as an indicator did not provide a meaningful link between labor market conditions and wage growth."

The other reasons provided for discontinuation are that "model estimates turned out to be more sensitive to the detrending procedure than we had expected" and "the measurement of some indicators in recent years has changed in ways that significantly degraded their signal content."

I also noted in my blog post and on NPR that the index is almost perfectly correlated with the unemployment rate, meaning it provides very little additional information about labor market conditions. (Or interpreted differently, meaning that the unemployment rate provides a lot of information about labor market conditions.) The development of the LMCI was part of a worthy effort to develop alternative informative measures of labor market conditions that can help policymakers gauge where we are relative to full employment and predict what is likely to happen to prices and wages. So since resources and attention are limited, I think it is wise that they can be directed toward developing and evaluating other measures. 

Wage Increases Do Not Signal Impending Inflation

When the FOMC meets over the next two days, they will surely be looking for signs of impending inflation. Even though actual inflation is below target, any hint that pressure is building will be seized upon by more hawkish committee members as impetus for an earlier rate rise. The relatively strong May jobs report and uptick in nominal wage inflation are likely to draw attention in this respect.

Hopefully the FOMC members are aware of new research by two of the Fed's own economists, Ekaterina Peneva and Jeremy Rudd, on the passthrough (or lack thereof) of labor costs to price inflation. The research, which fails to find an important role for labor costs in driving inflation movements, casts doubts on wage-based explanations of inflation dynamics in recent years. They conclude that "price inflation now responds less persistently to changes in real activity or costs; at the same time, the joint dynamics of inflation and compensation no longer manifest the type of wage–price spiral that was evident in earlier decades."

Peneva and Rudd use a time-varying parameter/stochastic volatility VAR framework which lets them see how core inflation responds to a shock to the growth rate of labor costs at different times. The figure below shows how the response has varied over the past few decades. In 1975 and 1985, a rise in labor cost growth was followed by a rise in core inflation, but in recent decades, both before and after the Great Recession, there is no such response:

Peneva and Rudd do not take a strong stance on why wage-price dynamics appear to have changed. But their findings do complement research from Yash Mehra in 2000, who suggests that "One problem with this popular 'cost-push' view of the inflation process is that it does not recognize the influences of Federal Reserve policy and the resulting inflation environment on determining the causal influence of wage growth on inflation. If the Fed follows a non-accommodative monetary policy and keeps inflation low, then firms may not be able to pass along excessive wage gains in the form of higher product prices." Mehra finds that "Wage growth no longer helps predict inflation if we consider subperiods that begin in the early 1980s...The period since the early 1980s is the period during which the Fed has concentrated on keeping inflation low. What is new here is the finding that even in the pre- 1980 period there is another subperiod, 1953Q1 to 1965Q4, during which wage growth does not help predict inflation. This is also the subperiod during which inflation remained mostly low, mainly due to monetary policy pursued by the Fed."

Wage Inflation and Price Inflation

Real wage growth has been disappointingly flat since the Great Recession. Reuters reports that "Most economists do not expect the U.S. central bank to raise benchmark rates until around the middle of next year, given sluggish wage growth." If and when wage growth picks up, I anticipate many debates about the relationship between wage inflation and price inflation by Fed officials and Fed-watchers. The Wall Street Journal blog recently wrote about how Fed-watchers should pay attention to wage growth as an indicator of inflation pressures:

Wage growth is a sign of labor market health but also spills into the Fed’s other mandate: price stability. Labor costs are the driver of costs for most businesses overall. Bigger pay gains push businesses to mark up their own selling prices, leading to higher inflation overall.

But the transmission of wage growth to growth in prices is not straightforward or perfectly understood. It is not safe to assume that firms translate some fixed proportion of labor cost increases into price increases. A 1997 New York Fed study called "Do Rising Labor Costs Trigger Higher Inflation?" found that the answer to its title question is, "It depends." There are several major groups of industries for which labor cost increases and price increases are not directly linked. In industries with high import-penetration ratios, global competition limits firms' abilities to translate higher unit labor costs into higher prices. In some large industries such as utilities, public transportation, and medical care, the government plays a large role in setting prices, so there is not a direct transmission of increased labor costs into increased prices. Housing prices are little affected by rising labor costs because the short-run supply of housing is essentially fixed, so prices depend more on land values and material costs than on labor costs. And finally, some firms are able to respond to labor cost increases by taking steps to increase productivity to maintain profitability without raising prices. The study finds that only in the service sector are cost increases easily passed on to customers.

The relationship between wage inflation and price inflation may be even more tenuous in the context of the post-Great Recession labor market. A new Cleveland Fed study that just came out today, by Edward Knotek II and Saeed Zaman, readdresses the question of whether rising labor costs trigger higher inflation. They look at the cross-correlations of inflation and various wage measures. Their cross-correlation graphs below are meant to show how inflation is correlated with future or past wage growth, as an indication of whether price inflation predicts wage inflation or vice versa. Using data from 1960-present, there is moderate positive correlation at several leads and lags, suggesting that price inflation and wage inflation move together, without one clearly preceding the other. When they use data only from 1984-present, the correlations are still positive, but smaller, indicating a weaker relationship between wage inflation and price inflation in more recent decades.

 

While Knotek and Zaman only break the time sample into pre- and post-1984, there is reason to believe that the relationship between wage and price inflation may have changed since the Great Recession. For instance, the figure below, from Cleveland Fed researchers, shows that labor income as a share of total income is extremely low by historical standards. This means that firms facing rising labor costs may have a bit more flexibility than usual to absorb the cost increases rather than passing them on to customers.

Several Federal Reserve surveys attempt to gauge firms' perceptions and expectations of their cost increases and price changes. The New York Fed's Empire State Manufacturing Survey is a monthly survey sent to about 200 manufacturing executives in New York State. The executives are asked about current business conditions and their expectations of conditions in six months. Several of the questions ask about prices paid (for inputs) and prices received (for sales).

In the just-released August survey, 30% of firms say they are paying higher prices, but only 16% say they are receiving higher prices. And 47% expect to pay higher prices six months from now, but only 31% expect to receive higher prices. The discrepancy between changes in prices paid and changes in prices received suggests that these firms will not be fully passing on increased input costs to customers. A supplemental section of the Empire State Manufacturing Survey this month asked firms about their response to the Affordable Care Act, and 36% said they will increase or have increased the prices they charge to customers as a result of the Act.

The Atlanta Fed also surveys businesses about cost and price expectations.  This survey asks respondents how various factors will influence the prices they charge over the next 12 months. Just over half of firms expect labor costs to have a "moderate upward influence" on the prices they charge, and another third of firms expect labor costs to have little or no influence on the prices they charge. Meanwhile, 64% of firms expect non-labor costs to have moderate upward influence on the prices they charge and 24% expect non-labor costs to have little or no influence. A special question on the latest round of the Atlanta Fed survey asked about year-ahead compensation expectations. Firms expect an average 2.8% compensation growth (see figure below).

An important takeaway from Knotek and Zaman's study is that "given wages’ limited forecasting power, they are but one piece in a larger puzzle about where the economy and inflation are going."

Accounting for Changes in Inequality

The Berkeley macroeconomics reading group has three themes for this semester: (1) factor shares, wealth, and inequality, (2) misallocation, and (3) financial stability. Each week, a different student presents a paper from one of the topic areas. Today, as part of the first topic, I am presenting the paper "Accounting for Changes in Between-Group Inequality" by Ariel Burstein, Eduardo Morales, and Jonathan Vogel (2013).

Here are my slides. And here is the abstract:

We provide a framework with multiple worker types (e.g. gender, age, education), to decompose changes in aggregated and disaggregated between-group inequality into changes in (i) the supply of each worker type, (ii) the importance of different tasks, (iii) the extent of computerization, and (iv) other labor-specific productivities (a residual to match observed relative wages). The model features three forms of comparative advantage: between worker types and computers, between worker types and tasks, and between computers and tasks. We parameterize the model to match observed changes in worker type allocation and wages in the United States between 1984 and 2003. The combination of changes in the importance of tasks and computerization explain the majority of the rise in the skill premium as well as rising inequality across more disaggregated education types, whereas labor-specific productivity changes drive between-worker wage polarization.

The paper is motivated by the rise in the skill premium, fall in the gender premium, and rise in wage polarization (i.e. relative decline of wages in the middle.) The authors want to know about the role of computerization in these trends. An important idea of the paper is that certain types of workers (e.g. females) may either have a direct comparative advantage at using computers, or might have an indirect comparative advantage in the sense that they have a comparative advantage in occupations in which computers have a comparative advantage. In the first case, we would observe female workers using computers more than males within the same occupation. In the second case, we would observe females being over-represented in the occupations in which all workers use computers a lot.

Using data on computer use and occupations for several years between 1984 and 2003, the authors find that, while women use computers more than men, this is due to indirect comparative advantage. Women are more often in occupations in which all workers use computers more. In contrast, highly educated workers have direct comparative advantage with computers-- they use computers more than less educated workers within the same occupations.

As the price of computers falls, the relative wages of workers with direct comparative advantage in computers rises. So computerization can explain some of the rise in the skill premium (that is, the rise in wages of more educated compared to less educated workers.) A major part of the rise in the skill premium is also attributed to "task shifters," that is, factors like structural changes and international trade that alter the relative demands for workers across occupations.

Computerization does not raise the relative wages of workers with indirect comparative advantage in computers, so computerization does not explain the fall in the gender premium (that is, the fall in male compared to female wages). Both the fall in the gender premium and the relative decline of wages in the middle are attributed to changes in "labor productivity," which in this model is a residual term, meaning it is not actually explained by the model.