PPI Surge Unlikely to Impact CPI

Summary

• The recent pick up in PPI will likely be absorbed through productivity gains and stagnant wages rather than higher CPI inflation.
• The transmission of PPI inflation acceleration to CPI would require stronger workers’ bargaining power, which is a few years away.

Market Implications

• Downside to BEs; real yields to rise as they are out of step with real GDP growth.

PPI Has Limited Predictive Power for CPI

The recent pick up in PPI inflation has prompted warnings that CPI inflation is about to accelerate (Chart 1). In reality, the correlation between PPI and CPI is spurious and reflects that, for both indices, energy prices are the greatest source of volatility. Strip PPI and CPI of their energy components and the correlation is much weaker.

The PPI/CPI overlap is strongest in the goods category of consumer spending. Since the late 1990s, however, core consumer goods PPI prices have consistently increased by more than core goods CPI prices. This suggests falling manufacturing profit margins, yet manufacturing profits as a share of manufacturing GDP have been increasing. I believe this apparent paradox reflects workers’ weak bargaining power.

Wages have increased by much less than productivity since the mid-1980s, with the gap widening faster from the late 1990s onwards. Wage growth caught up with productivity only after 2015, but even then, the gains were modest. This reflects an imbalance between workers’ and employers’ market power built over decades of globalization, technological change, pro-employer laws and regulations, weaker unionization and greater concentration of employers. The imbalance is also reflected in the trend decline of the income share of employees.

Both income share and wages relative to productivity increased after 2015 due to labour market tightening, i.e., a cyclical increase in workers’ market power. The structural factors suppressing labour income remain unchanged, however.

With workers’ bargaining power weak, firms use productivity gains to absorb cost increases rather than raise wages. This allows them to maintain profits despite cost increases and keeps goods CPI inflation low despite steady PPI inflation.

For PPI inflation to translate into CPI inflation, workers’ bargaining power would have to increase. This would ignite a wage-price spiral, which BoJ Governor Haruhiko Kuroda reminded us is a necessary condition for inflation acceleration. Stronger workers’ market power is unlikely any time soon due to the current very large labour market slack. Over the longer run, the administration intends to implement pro-worker policies. However, these will take time to impact the labour market power structure. Meanwhile, the pandemic has likely unleashed new productivity-enhancing business practices that could reduce the labour intensity of the recovery and further undermine workers’ bargaining power.

Inflation could remain low even once the labour market tightens, as the pre-pandemic experience shows. Pre-pandemic, firms were widely reporting shortages of workers but not raising wages. Post-GFC, the Beveridge curve shifted right, i.e., vacancies rose relative to unemployment. Simultaneously, post-GFC wage increases have been more moderate relative to the vacancies/unemployment ratio. That is, despite complaining of lack of skilled workers, employers were not trying to bid up their wages.

This low inflation equilibrium could reflect the influence of large retailers, which act as leaders in increasingly concentrated markets for goods and services. Alternatively, it could reflect the self-reinforcing nature of workers’ and employers’ low inflation expectations. BIS analysts have recently argued that, just as successful disinflation has often required a social compact coordinating wage and price moves, the re-anchoring higher of inflation expectations could also require some form of wage and price coordination.

The bottom line is that raising inflation will be complicated. The discussion above suggests that, on its own, the Fed AIT may be insufficient. Current market-based inflation expectations could therefore be overoptimistic. This does not imply, however, that bond yields have no upside as real yields seem mispriced, even after accounting for the post-GFC widening of the GDP/real rates spread.