What’s at stake
Jeremy Rudd is making waves in central-banking circles by challenging a key belief held by the likes of Federal Reserve Chair Jerome Powell. A senior adviser at the Fed, Rudd has attacked the notion that people’s price expectations today influence future actual inflation rates. Airing heretical views is always useful. And if he is right, policymakers may be looking the wrong way.
Powell and others talk a lot about the importance of keeping inflation expectations “anchored”. But Rudd reckons that is not a big reason why wage growth – an important driver of sustained price increases – has remained in check since the mid-1990s. Instead, he argues in a recent paper that inflation was low enough during this time not to figure on workers’ radar and therefore didn’t much influence their decisions. If inflation rates get high enough to be noticed, a threshold Rudd says was around 3% in the mid-1960s, things may change.
Rudd’s provocative paper stakes its claim in his very first sentence: “Mainstream economics is replete with ideas that ‘everyone knows’ to be true, but that are actually arrant nonsense.” And it is not just an academic disagreement. The corollary of his argument is that central bankers are underestimating the risk of allowing prices to rise significantly faster than their targets. If doing so puts inflation back on people’s radar, that could trigger a wage-price spiral. That might then require a sharp tightening in monetary policy, denting central bankers’ credibility and, more importantly, the economy and financial markets.
Rudd suggests a couple of indicators. One is whether the rate at which people are quitting jobs increases in a way that looks more closely correlated with consumer prices than with the health of the labour market. Another is whether wage increases for new hires are outpacing those for employees who stay in their jobs. Either might foreshadow a wage-price spiral because wages for new joiners are more responsive to changes in the economic climate.
Pandemic distortions mean it’s currently harder than usual to parse labour data. But so-called quit rates in the United States are rising and there’s a widening gap between wage growth for new and existing American workers. Central bankers like Powell are running an inflation experiment, and they need to be alert for signs their hypothesis is flawed. Rudd’s critique gives them some things to watch for.