Friday, June 16, 2006

On Forecasting Inflation

Several readers have asked me to weigh in on the Krugman-Cecchetti debate on whether inflation is about to calm down or take off. I don't have a dog in this fight. I posted the two views because it is interesting whenever two economists as smart as Paul and Steve reach diametrically opposite conclusions. It is always food for thought.

Paul's view, as I understand it, is that we need not worry about inflation until we see inflation in nominal wages. He points out (correctly) that labor is the largest component of costs. He reasons that if the cost of labor grows slowly, as it has recently, inflation in the prices of goods and services won't be a problem. The logic is almost, but not quite, compelling.

Steve has a more purely data-oriented approach to the issue. His thinking is informed more by time-series econometrics than by a particular theoretical model of wage-price dynamics. Here is what econometricians say about Paul's hypothesis:
Lags of nominal wages do not seem to add information beyond that contained in lags of prices.
That quotation is from "Forecasting Inflation" by James H. Stock and Mark W. Watson (Journal of Monetary Economics, Volume 44, Issue 2, October 1999, Pages 293-335). Stock and Watson are two of the best applied econometricians around.

How should one reconcile Paul's observation that wages are a large part of costs with this time-series result that wages don't help forecast inflation? I don't know. (Students looking for thesis topics: Your ears should perk up now.)

One possibility is that nominal wages are a lagging indicator of inflation. Maybe the prices of goods and services have a dynamic of their own, perhaps described by some kind of Phillips curve, and nominal wages respond with a lag to prices. This is consistent with a view of labor markets in which wages are not allocative in the short run but, instead, are more like installment payments on long-term contracts. If that is the case, then one should not take much solace in Paul's observation that nominal wage inflation has been contained.