Rising Productivity Will Finally Tame Inflation

The latest monthly US jobs report showed a moderation in employment growth, bolstering hopes that the Federal Reserve can stop raising interest rates. Not so fast, say the monetary policy hawks such as former Treasury Secretary Larry Summers. They point to elevated wage gains as a cause for concern. Specifically, Summers estimates that when combined with trends in productivity, the fatter paychecks indicate an inflation rate of around 3.5%, which is uncomfortably high for the Fed and begs for tighter monetary policy. That estimate sounds overly pessimistic to me.

This may all sound academic, but the debate is central to whether the Fed will be able to achieve a fabled “soft landing” in the economy, getting inflation under control without inflicting broader damage or whether its rate hikes will cause a crushing recession, resulting in millions of workers losing their jobs.

The Summers argument is based on the idea that wage growth is equal to productivity growth plus inflation. So, if wages are expanding at a 5% clip and productivity is increasing at 1.5%, then inflation must end up accelerating at a 3.5% rate. In this world, wage growth would have to slow considerably for inflation to continue to moderate. Otherwise, employers will see their labor costs eat steadily into profits, as they increase pay without enjoying an equivalent increase in productivity. Such an environment can only last for a short while, as businesses will eventually feel the pressure to start raising prices for their goods to make up for increased labor costs.