Paying the Price for Low Inflation

Economists remain obsessed with inflation, but could suppressing rising prices also be clamping down on wages as well

Inflation has long been an obsession for economist, so much so that it is the basis around which monetary policy is set. As such, central banks are charged with making sure we have a little bit of inflation, not too much or too little. It is a policy framework that was put in place after the stagflation of the 1970s when the economies in Western countries were plagued with high inflation and lots of unemployment.  For good or bad, monetary policy has remained stuck in the same mold.

Monetary policy continues to involve raising or lowering interest rates to keep inflation in the “Goldilocks” range of close to two percent. Central bankers must keep up persistent vigilance as, were inflation to escape from this range, getting inflation back under control is seen as potentially problematic. This is because changes in the price level are thought to affect how people think prices will move in the future. Higher inflation now, for example, would create a feedback loop to create even higher inflation, as it is thought to have happened in the 1970s.

The story goes that, back in the 1970s, trade unions pushed for more pay as the oil price shock pushed up the cost of living.  Companies responded to a bigger wage bill by increasing prices, which thus fed into demands for even more wage hikes. It was only crushing high interest rates that stopped wages and prices spiraling out of control. Ever since, we have had central bankers aiming to keep their foot on the throat of inflation.

The notion of how expectations of the future can affect inflation has mainly focused on how wage gains feed through to higher prices. Low unemployment in recent years has kept central bankers on their toes as greater demand for workers is expected to translate into higher wages and potentially increases in the level of prices. Yet, this tightening of the job market has been relatively benign so that the Federal Reserve in the US has even cut interest rates.

Part of the reason behind the limited increases in wage (so far) is the extent to which expectations of inflation affect not only wages but also the actions of consumers and companies. Having become accustomed to prices remaining stable (if not edging downwards), consumers are likely to shun any business attempting to push up prices. Companies are likely to anticipate this and hold off from price hikes and say, for example, shrink the size of their product instead.

The focus on inflation thus adds to a number of forces that are already acting to keep a lid on prices. Globalization has allowed business to get access to cheaper raw materials and low-wage workers as well as boosting economies of scale in production. The Internet has also been a boon for those wanting to find cheaper prices.  Amid these changes, the scope for raising prices has been significantly curtailed.

The overall effect is to lock the economy into low prices. This doesn’t sound like a bad thing. But what benefits us as consumers has a negative impact when it comes to being paid. In the same way that higher wages can feed through to higher prices, leading to wages and prices to spiral upwards, the opposite could also be seen as happening. Low prices limit wages which in turn hurts spending and further depresses prices. Without much scope for increasing sales, company can only boost profits through reducing costs such as the wage bill.

The feedback mechanism can thus act to hold down growth in an economy. Yet, there seems little scope for a let-up as worries about inflation continue to dominate. Freeing up scope for higher wages would improve the lives of many people living on low incomes and would help with inequality. And the extra spending this would generate would be welcome at a time when spending remains subdued. With inflation proving less troublesome than in the past, we should think about whether low wages are worth paying the price.