Last week's edition of The Economist includes an article (available if you are a subscriber) postulating that globalization -- or globalisation, depending on your address -- explains why our recent bout of energy shocks have not translated into higher core inflation. Here's the essence of the The Economist's take:
First, the integration into the world economy of China and other emerging economies with vast supplies of cheap labour has curbed the bargaining power of workers in developed economies. These workers therefore find it harder to secure higher wages when inflation picks up. And second, fiercer global competition has made it more difficult for firms to pass increases in wages through to prices. Instead they must absorb them in their profit margins.
That passage comes to you from Angry Bear's Kash, who is no quite convinced. Kash's doubts are based on this observation:
If it is indeed true that, due to increased global competition, firms can't raise prices to pass along costs, then the increases in oil prices and wage rates of the past year or two should be reflected in sharply lower profit margins, as the article mentions. Yet corporate profits have grown rapidly, despite the equally rapid rise in oil prices.
That skepticism receives some support from a 2003 study by the Federal Reserve Board's David Bowman, who finds:
... at present there is no strong empirical evidence for this channel as a key explanation of low inflation in the 1990s. This mirrors the conclusion of the OECD Working Party on Macroeconomic and Structural Policy Analysis (2002), which examined detailed data for a large set of manufacturing industries and found \no systematic change" in competition in OECD countries as measured by pro¯t markups. It also is corroborated by previous estimates for the United States which have tended to indicate that on average U.S. firms are already fairly competitive, leaving only limited room for an increase in competition at the aggregate level.
Kash prefers a weak labor market explanation, but this is where I have my doubts. Beside my general qualms about correlating soft labor markets with moderating inflation, it is unit labor costs -- productivity-adjusted compensation to workers -- that matter for inflation. Here the evidence is not so clearly in the direction Kash wants to take the story:
I say not so clearly for two reasons. First, as the picture above shows, there are some mixed messages in the data. Unit labor cost growth in the total non-farm business sector clearly accelerated in the first part of the year. But some people argue that, because output in the non-corporate sector is poorly measured, statistics based on the non-financial corporate sector give a clearer glimpse at the truth. In that sector, the evidence of a big jump in labor costs is largely absent.
The second thing to note is that the data in the picture extends only through the second quarter of this year. Things may look differently when we get the first taste of things from the third quarter with the release of the GDP and the Employment Cost Index data this Friday, and the unit labor cost information a week from Thursday.
That notwithstanding, and at the risk of repeating myself, I prefer what I think is a simpler explanation for why energy prices are not feeding into core inflation: The FOMC has committed to making it not happen, and that commitment is credible.
Given the reaction to this afternoon's announcement from President Bush, I'll conjecture it is as credible today as it was yesterday.