The cruelty of managing (whose) expectations

Central banks have no way of preventing corporations from setting prices higher - and no one else is trying. So central banks have to convince 'the market' they're willing to cause a recession.

Last week was full of big news on the global macro-economic front. The US Federal Reserve, the European Central Bank, and the Bank of England all increased interest rates - but slower than they have been. All three hiked rates by 50 basis points (0.5 percentage points), instead of 75. But even though the rate of increases slowed, the message from all three was still “inflation is too high, we may have to increase rates more next year”. Inflation may have peaked, but central banks around the world are very much making sure not to signal ‘Mission Accomplished’ prematurely.

This messaging from central banks is meant to shape our ‘expectations’. Central banks believe that our collective predictions about inflation shape our behaviour - if businesses expect there to be inflation, they will all raise prices faster, and if workers expect there to be inflation, we will all ask for raises. In this way, expecting inflation to happen actually causes inflation to happen.

This is definitely happening on the business side - central bankers have admitted that they are seeing (especially larger) corporations pass through costs far faster than usual. And this shows up in corporate profits, as I’ve documented before for Canada, and as the European Trade Union Confederation has documented for Europe.

And if you haven’t seen it, Robert Reich has been doing a great job covering the US.

The truth I'm telling Congress today about inflation

But on the wage side, we’re not even keeping pace with inflation, let alone managing to get in front of it. So why are central bankers obsessed with wages and silent on profits?

Jay Powell, Chair of the US Federal Reserve, is concerned about the labour market’s influence on inflation, as he said in his November 30th speech,

In the labor market, demand for workers far exceeds the supply of available workers, and nominal wages have been growing at a pace well above what would be consistent with 2 percent inflation over time. Thus, another condition we are looking for is the restoration of balance between supply and demand in the labor market.

There are two issues that I have with this statement. First, this paragraph doesn’t make much sense for an economist. If something is in short supply then we would expect the price to keep going up until balance is restored. So in this case, if there really is a shortage of workers, we would expect wages to be rising even faster than inflation. That’s how you attract and retain workers in an industry with a labour shortage.

My second issue is where Powell puts the goal posts. He thinks nominal wage growth should be ‘consistent with 2 percent inflation’ over time. I think nominal wage growth should be at least on par with inflation. There’s no reason workers should accept real wage cuts, or this double standard - I see no one suggesting that nominal profits need to be ‘consistent with 2 percent inflation’!

Inflation is everywhere and always workers’ fault

This double standard is especially galling because there is no proof that wage increases even have the inflationary impact that Powell is worried about. I wrote about this a couple weeks ago.

In a rich man's world

The new story being told in the Financial Times is that higher wage growth is a problem because it means consumers keep buying too much (that is, demand continues to outpace supply). This is getting closer to the truth of the logic behind increasing interest rates until we’re at a recession, in my opinion. I often tell people when I’m invited to give a talk on inflation that when bankers or pundits or anyone says that demand is too hot - they mean that you and I have too much money in our pockets. They can’t make companies set prices lower, they can’t make us spend less money, but they CAN engineer a recession so that we *have* less money to spend.

Inflation as a business strategy

Political economist Blair Fix discusses the nature of inflation, coming to the conclusion that inflation happens when it makes sense as a business strategy for firms to increase prices. And he notes that there are all kinds of dynamics that can create that situation, but we almost never talk about them. Or about what the solutions would be. So we keep repeating the same mistakes, over and over again.

Discouraging profiteering?

Everyone sees corporations and landlords setting prices higher, but no one (read, elected governments) is willing to do anything about it. There are very few price controls left in capitalist economies - we have some weak and patchy rent controls, for example. So the only tool left to use is increasing interest rates, to hopefully lower business investment, and eventually (the point), weaken labour markets.

Some governments have recently started implementing windfall profits taxes, mostly focused on oil and gas, to try and reduce profiteering, and redistribute profits where they are most needed. Marc Lee at the CCPA in BC makes a great case for Canada to implement a windfall profits tax on oil and gas. For me, I think it would make sense to have a broader and permanent windfall profits tax, or just restore higher corporate tax rates. Both would help discourage profiteering.

Edit: I forgot to say - the best way to prevent profiteering is through (drum roll please), collective ownership models - co-ops, worker co-ops, public ownership, etc. Jurisdictions that own their own energy companies (for example) see a lot less profiteering in energy prices.

Easier to discourage workers

But in the absence of that, we have forward guidance from all of the major central banks, including the BoC, that they are willing to go further to make sure that they’ve weakened labour markets at least enough to dampen demand. I had hoped that strong-ish labour market would mean a soft landing was more likely - but it seems like from the messaging we’re getting, we won’t be so lucky.