The bad news from this week's Producer Price Index report for September was that the overall inflation number exhibited the same extraordinary spike we saw in the Consumer Price Index report last week. The worse news was that, unlike core CPI, core PPI took a jump as well. From the PPI report:
Excluding prices for foods and energy, the finished goods index increased at a 2.6-percent SAAR for the 3 months ended September 2005, after rising at a 1.0-percent SAAR for the 3 months ended June 2005.
The report moved Kash at Angry Bear to speculate whether the energy costs that are clearly driving overall consumer and producer prices might not soon yield a more general inflation, as would be reflected in higher rates of core inflation. Kash says not necessarily, and discusses the conditions under which he thinks they might or might not:
... individuals are finding that the purchasing power of their paychecks have been sharply eroded, as the price for the average bundle of goods that they buy has risen by nearly 5% over the past year. If workers can successfully demand higher nominal wages to compensate for this loss in purchasing power, then we might start to see nominal wages rising faster, which in turn would increase business costs further and lead to even greater pressure on businesses to raise prices for all types of goods and services. However, this depends crucially on the ability of workers to extract wage increases from their employers, which in turn depends largely on the strength of the labor market.
I don't have a lot to quarrel with in that assessment, but I think I would avoid phrases like "depends largely on the strength of the labor market." As we know, rising wages are not inflationary as long as unit labor costs are not rising -- that is, as long as higher wages are being driven by advances in labor productivity. A perfectly strong labor market is wholly consistent with perfectly stable prices.
I am away from my access to the dusty old FOMC transcripts at the moment, but my recollection from the record of the early 1970s was that Arthur Burns on several occasions pronounced that it was just not reasonable to expect inflation to persist because labor markets were so weak. History, I believe, revealed that as not such a good call. The reason it was not, in my opinion, is because it neglected the fact that inflation was, and still is, primarily a monetary phenomenon.
The issue really is not weak or strong labor markets. It does not take falling real wages to generate a decline in the inflation trend. What matters is the inflation psychology of the moment. The dreaded wage-price spiral can arise because workers and businesses alike believe that individual nominal wages and prices can be increased simply because all other wages and prices are changing. And they can come to those beliefs if they are convinced that the central bank will make it so. In this case rising wages are a symptom of the problem, not a cause.
Yesterday, my boss put it this way:
Looking forward into 2006... We are likely to have a moderately expanding economy, in which the headline inflation numbers gradually slow down and move into line with the much-lower core inflation rate.
Likely, that is, if monetary policy does its part to keep those temporary pressures from translating into more persistent inflation. Temporary inflation will turn into longer-term inflation only if the FOMC allows expectations of persistent inflation to build.
You will not, I presume, be surprised to hear me second that opinion.