Inflation? It’s Import Prices and the Labor Share!

Abstract

Recognizing that inflation of the value of output and its costs of production must be equal, we focus on a cost-based macroeconomic structuralist approach in contrast to micro-oriented monetarist analysis. For decades the import and profit shares of cost have risen, while the wage share has declined to around 50% with money wage increases lagging the sum of growth rates of prices and productivity. Conflicting claims to income are the underlying source of inflationary pressure. Inflation affects income (labor’s spending power) and wealth. Monetarist theory around 1900 concentrated on the latter (Bryan and the “Cross of Gold)” leading to the standard Laffer curve. It was replaced by the Friedman-Phelps model which has incorrect dynamics (labor payments do not fall during an expansion – they go up). Samuelson and Solow introduced a version of the Phillips curve that violates macroeconomic accounting. Rational expectations replaced Friedman but was immediately falsified by output drops after the Volcker shock treatment around 1980. There followed a complicated transition from rational expectations to inflation targeting, anchored by economists’ misunderstanding of the physical meaning of ergodicity and ontological blindness. It did not help that the real balance effect is irrelevant because money makes up a small part of wealth. Rather than issuing veiled threats of disaster if its policy advice is not followed, the Fed now announces inflation targets which it cannot meet. Contemporary structuralist theory suggests that conflicting income claims set the inflation rate. Firms can mark up costs but workers have latent bargaining power over the labor share that they can exercise. Import costs and policy repercussions complicate the picture, but a simple vector error correction model and visual analysis suggest that money wages would have to grow one percentage point faster than prices plus productivity for several years if the Fed is to meet a three percent inflation target. The results pose a Biden policy trilemma: (i) the only path toward a more egalitarian size distribution of income is through a rising labor share (money wage growth exceeds price plus productivity growth), (ii) which would provoke faster inflation with feedback to rising interest rates, and (iii) the resulting asset price deflation likely facing political resistance from Wall Street and affluent households.