“Kee” Points with Jim Kee, Ph.D.

  • Wages and Inflation
  • Mnuchin’s Statement Before House Committee
  • Once More on the Dollar!


Wages and Inflation

Treasury Secretary Steven Mnuchin has been in the press lately for several comments. One statement of Mnuchin’s that has gotten a lot of attention is the assertion that, “You can have wage inflation and not necessarily have inflation concerns in general” (Bloomberg). I agree with that, but probably for different reasons then Mnuchin. I’ll take three stabs at this, but first, back to Money and Banking 101:

Ours is a fractional reserve banking system: When you deposit $100 in your bank, the bank has to hold a portion as reserves (i.e. “required reserves”), call it 10 percent, and loans the rest (90 percent) out. Typically, the reserves are held on account at the central bank, the Federal Reserve. Whoever borrows it deposits it in their bank, which then holds a portion on reserves and loans the rest out. On it goes, as the original $100 deposit gets multiplied throughout the banking system, a process known as the money multiplier. Traditionally, banks haven’t held reserves in excess of the required amount (which would be called “excess reserves”) because they don’t earn money on those reserves. But since the Fed’s extraordinary asset purchase programs undertaken during the financial crisis, in which the Fed bought securities from the banking system and credited them with reserves, the excess reserves of the banking system are near all-time highs. Inflation would occur if those excess reserves started getting loaned out and multiplied through the banking system. The Fed knows this and put several programs in place to allow it to “control” these excess reserves in ways it didn’t have before the financial crisis. But the Fed’s ability to control those excess reserves is central to the question of whether we’ll have high, double-digit inflation in the future. Inflation expectations have picked up a bit, but so far it hasn’t been a problem. Now, on to Mnuchin’s comment:

If people in the aggregate (i.e. the whole economy) have to spend more money on labor (pushing up labor’s price, which is wages), then they have less money to spend on other things, which puts downward pressure on their prices – for a given quantity of money. You can’t spend more on everything with a given stock of money. The only way you can spend more on everything is to have more money. So, whether or not wage growth (or commodity price growth, or import price growth) leads to inflation depends upon what’s happening to the money supply at the same time. That, in-turn, depends upon what central bank policies are at the time. It gets a little complicated in a world of fractional reserve banking, particularly in a period like today where the excess reserves of the banking system are at record highs, but that’s the way to think about it. Whether or not any development is or is not inflationary depends upon the organization and actions of the central bank (which controls components of the money supply) that are occurring at the same time.

This is really a specific example of what economists call the “fallacy of composition,” or assuming that what is true for a part is true for the whole. Academic economists refer to it as applying “partial equilibrium thinking” when “general equilibrium thinking” is required. Don’t let the words that economists borrow from physics, like equilibrium, intimidate you. In partial equilibrium analysis, you change one thing while holding everything else constant. In general equilibrium analysis, you all allow everything else to change. When people assert that wage growth will lead to inflation, they are using partial equilibrium analysis, specifically, holding all other prices in the economy constant. But inflation analysis requires looking at the economy as a whole, or allowing all other prices to change. And as I hope the paragraph above made clear, you can’t hold spending constant on everything else (so their prices don’t change) if you are increasing spending on wages. If you spend more somewhere you have less to spend elsewhere. Anyway, economist Milton Friedman once called the fallacy of composition the most common thinking error committed by both layman and professional economists alike. You see it a lot in spending discussions that otherwise seem to make intuitive sense. For example, you often hear that, “if mortgage rates rise, then consumers will have less money to spend on other things, so spending on other things declines.” But don’t the people selling those higher rate mortgages now have more money to spend on other things? Isn’t the fewer dollars left in a home buyer’s pocket because of having to pay higher mortgage rates exactly off-set by more dollars in the mortgage originator’s pocket who is receiving those higher rates? In other words, doesn’t aggregate spending remain unchanged?

Economists make a distinction between two things: (1) relative price movements, versus (2) general price movements or, inflation. A relative price movement is the change in the price of one thing relative to the price of other things. That describes changes in oil prices, or import prices, or wages (labor’s price), etc. On the other hand, when economists want to talk about a change in all prices, or a general price movement, they use the term inflation. So, an increase in the price of some things, like wages (a relative price movement), is distinct from an increase in all prices, which is inflation. Confusion starts when people use the word “inflation” to talk about what is really a relative price movement. For example, they use the term “wage inflation,” or “commodity inflation,” or “housing inflation.” Even economists do this, as it creates an economy of expression. When you say there is a lot of wage inflation, people immediately know that what you are saying is that wages are rising. But that economy of expression comes at the expense of forever muddling the discussion of a rise in all prices, which is inflation proper.

What about the government's excess borrowing, won’t that lead to inflation? The government issues debt, which is purchased in the open market. The central bank (i.e. the Federal Reserve) cannot buy debt directly from the Treasury, which is known as debt monetization. It buys debt in the open market (from the banking system) and credits the banks with reserves equal to what it purchased. So, it all goes back to the point made in the first paragraph, that is, it only becomes inflationary if these excess reserves are loaned out too quickly. Again, controlling those excess reserves is the key. And remember, some countries - like Japan - have government debt that is multiples of their national incomes, and Japan has been fighting deflation for decades.

Mnuchin’s Statement Before the U.S. House Committee on Ways and Means

Another thing Mnuchin asserted was that the key to returning to robust growth lies in deregulation and the Tax Cuts and Jobs Act. I know I have mentioned before that this has been overlooked somewhat; that is, a business tax cut will be more conducive to growth in a strong deregulatory environment than it would be under a growing regulatory environment. The regulatory “tone” that Washington takes has always been deemed important to business spending, going back to FDR advisor Jacob Viner, a truly legendary Princeton and University of Chicago economist. But it is hard to quantify and thus often ignored in academic studies.

Once More on the Dollar!

In a recent Kee Points, I described the dollar’s recent behavior over the past several years as being driven by the “safe have” property that the dollar has displayed since the financial crisis. When concerns are high, people move into safe, dollar-denominated assets, like US Treasury bonds, driving up their price and lowering yields, and the dollar rises. Riskier assets like stocks pause or decline in price, including things like high-yield or junk bonds (i.e. “quality spreads widen”). The opposite occurs in ‘risk-on’ environments as people move out of dollar-denominated safe haven assets - the dollar declines - and into riskier assets (e.g. stocks, junk bonds, etc.) whose prices rise. This has been described variously as “the dollar acts as a barometer for risk” (BNY Mellon) or as a rising rate, falling dollar environment being a ‘risk on’ period (Wells Fargo Securities). I think that is a good way to interpret recent dollar movements. Also, remember economist Robert Mundell’s comments, that the dollar/euro relationship is the price to watch: When the euro increases above, say, $1.30, then the euro is too strong. Too far below $1.20 and the dollar is too strong. At the beginning of last year, the euro traded close to $1.00, and has since moved up to about $1.22. Again, that seems like a normalization to me.