Why weak nominal wage growth is of concern to flexible inflation targeters

Today’s UK labour market data show nominal wage growth falling back – to about 2% annual growth, from a local peak last year of 3% – at the same time as the employment rate increases.  This is another important interregnum for those who thought the UK economy was following a trajectory that would justify a first hike in rates and the beginning of the process of normalising monetary policy.

Recent speeches by both Vlieghe and Carney on the MPC warned that nominal wage growth and other inflation indicators had to show clear signs of picking up before they were prepared to raise rates.

But students of modern monetary policy models will know that these models suggest monetary policy pay attention to nominal wages not just in so far as they are potentially indicators of future inflation, but for their own sakes too.  In these models, stabilising nominal wages around their long run growth rate is just as important as stabilising inflation around its target.

The mandate itself does not give the MPC a nominal wage growth target.  But its signal to support the government’s objectives of achieving ‘strong, sustainable and balanced growth‘, and the March 2013 review of the mandate by HMT which explicitly characterised what MPC should be doing as ‘flexible inflation targeting’ gives policy makers ample scope, in my view, to place independent emphasis on stabilising nominal wages.

You might wonder whether having this independent concern for nominal wages makes a difference, if they are anyway an important indicator of future inflation.

There are 3 things to say about this.

First, central banks have a long history of debating in fact whether short run correlations imply that nominal earnings follow inflation, rather than signal future inflation.  If you care independently about nominal wages, this debate is less relevant.

Second, a shift in labour’s bargaining power [or equivalent concepts] could well mean that nominal wages decelerate at the same time as firms’ prices accelerate.  Caring independently about nominal wages means that one would not respond to such a change by simply accommodating all of the nominal wage fall.  Policy would be faced with a trade-off.  [This is topical as on some measures core inflation has surprised on the upside].

Third, without a motive to care independently about nominal wages, these data become just one out of several pretty noisy indicators of future inflation that it may be easy to find reasons to downplay.   Not so if policy ought to care about nominal wage growth for its own sake.

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7 Responses to Why weak nominal wage growth is of concern to flexible inflation targeters

  1. Nick Rowe says:

    “But students of modern monetary policy models will know that these models suggest monetary policy pay attention to nominal wages not just in so far as they are potentially indicators of future inflation, but for their own sakes too.”

    Because we should target the stickiest prices, and some of those stickiest prices might be wages? (Just checking.)

    I get the idea behind this, and it makes sense, but I still have doubts. Because in the limit, as the price of apples gets stickier and stickier, until it’s stuck, you can’t target the price of apples at all. It only works if one of the apple producers has a flexible price, but is in all other respects exactly like the other apple producers. Which doesn’t seem plausible.

    • Tony Yates says:

      This is for models where some in the sector get to change prices, but only with low probability, and some don’t. So the reason you want to stabilise prices is so that those that can’t change aren’t penalised for the rigidity, which can’t be helped any other way. So your intuition is bang on. The same result crops up if you look at models with two different sectors where goods prices are sticky to different degrees. It turns out to be optimal to ignore the flex price sector. Some cb’s have mentioned this in the context of targeting ‘core inflation’ which usually means lopping off food and energy, two sectors where prices are pretty flexible relative to other sectors, or so it’s claimed.

      • Nick Rowe says:

        Tony: ” The same result crops up if you look at models with two different sectors where goods prices are sticky to different degrees. It turns out to be optimal to ignore the flex price sector.”

        I want to be sure I understand you there.

        Apple sector and banana sector (many varieties of apples, and bananas). Both sectors equal size (on average). The Calvo fairy prefers apples, so she visits apple firms with a greater probability than she visits banana firms. Fluctuations in the weather change the equilibrium relative price of apples to bananas. So the central bank should target a basket that contains 100% bananas?? Or target a basket that is more than 50% bananas, but does contain some apples? I would have thought the latter, because smooth objective functions are relatively flat near the maximum.

      • Nick Rowe says:

        But if and only if the price of apples is *perfectly* flexible, the basket should be 100% bananas.

      • Tony Yates says:

        I think that’s correct. If I recall this was worked out in a paper by Aoki.

      • Nick Rowe says:

        Thanks Tony. I always want to make sure my intuition lines up with your knowledge of the models.

        Good post by the way.

      • Tony Yates says:

        Your intuition is razor sharp!

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