Here’s your no-brainer statement for the day: Unemployment is still really high. The unemployment rate was 8.2% in March, and has decreased only marginally in the last year. Worse still, there appears to be little relief in sight. The Federal Reserve Bank of Philadelphia’s most recent Survey of Professional Forecasters expects the unemployment rate to remain as high as 7.9% next year and 7.4% in 2014. While there are many reasons unemployment has been stubbornly high since the recession (weak consumer demand, ongoing deleveraging of debt, etc.), “sticky wages” may also be keeping the jobless from getting back to work.
During a recession, most firms are faced with some difficult employment choices. As demand for goods and services falls, many companies need to cut back on costs to avoid taking losses that can run them out of business. That means reducing labor and capital expenses. Since the latter is typically fixed in the short run (it is difficult to quickly close plants, sell machinery, etc.) the burden often falls on labor. And when it comes to labor there are two ways for a company to reduce its wage bill: employ fewer workers or pay workers less.
Companies often choose the former. For whatever the reason, most firms choose to reduce the workforce instead of reducing wages or benefits. One reason may be that nominal cuts to wages are less popular to the remaining employees than layoffs, reducing morale. This is what it means for wages to be “sticky”. Even though demand for labor has decreased, the price of labor is resistant to downward changes in the short run. That makes labor overpriced, which results in companies using less of it.
Companies that use less labor is just another way of illustrating that unemployment remains high. (By the by, if you are skeptical that companies are reluctant to cut wages, this economic letter from the Federal Reserve Bank of San Francisco gives a great analysis. In short, they find “The fraction of workers reporting a wage change of zero [from the previous year] is higher now than at any point in the past 30 years.”)
So how can companies make these sticky wages “unstuck” without applying wage cuts? By simply letting inflation erode away real wages over time. If you freeze nominal wages (don’t offer raises or cut wages) inflation will eventually decrease real wages without all the nasty side-effects of nominal wage cuts or layoffs. Nominally, you are not paying your employees any less than before, but inflation has reduced their purchasing power, thus decreasing the real wage. (In case you are curious, there is a reason why employees are OK with this de facto pay cut: the money illusion, which states that people tend to think of money in nominal terms, not real terms, thus paying no heed to the fact that a freeze in nominal wages is the same as a decrease in real wages.) For companies, on the other hand, inflation makes the price of goods and services increase over time, which raises revenue. When coupled with stagnant employment costs, this new profit lets companies potentially hire more workers, which reduces unemployment.
You might be wondering, “Unemployment is still above 8%. Why hasn’t this process played out during our most recent recession and recovery?” Well, companies have frozen nominal wages. But inflation has been so low that it has made little progress eating away at real wages. Since the end of the recession, inflation has been subdued – around 2% or less. Without a reduction in real wages, companies’ labor costs will remain tied up with its existing employees, leaving nothing for potential hires.
So there’s an argument to be made for the Federal Reserve temporarily increasing inflation through open market operations or further quantitative easing. But there are possible pitfalls to allowing inflation to run above the unofficial target of 2%. One of the pitfalls is that increasing inflation depresses the wages of workers, but companies don’t spend their newfound profit on new employees. They might hoard cash for a rainy day, pay down existing debts (particularly applicable in the current recovery) or invest in other factors of production. This scenario would further exacerbate a problem of weak consumer demand. There is also the risk of rising inflation spiraling out of control, or increasing more quickly than anticipated. This carries all the costs to the economy associated with high inflation: market inefficiencies, shoe-leather and menu costs, and the risk of hyperinflation. Also, a surprise upward adjustment of the Fed’s target rate of inflation may shake confidence in the Fed, creating further uncertainty and tampering with expectations of future inflation.
Obviously, the Federal Reserve currently believes that the risks of inflation rising above 2% are greater than the benefits of a quicker recovery in employment. After all, Ben Bernanke is well aware of the Fed’s dual mandate to maintain stable prices and maximize employment, yet inflation has remained the monetary policy focus. Would increasing inflation quicken the recovery in employment? It almost certainly would help. But would it outweigh the associated risks? Apparently Bernanke doesn’t think so.