Do workers cause inflation?

In the quarter ending in September the employment cost index rose at the fastest pace in two years, leading the Wall Street Journal to conclude:

U.S. employment costs accelerated during the third quarter at their quickest pace in over two years, suggesting that a tight jobs market is putting some upward pressure on labor costs, which will likely keep Federal Reserve officials on edge about inflationary risks in the economy.

The latest report suggests labor costs have the potential to keep underlying inflation high despite the damping effects of the recent drop in energy prices. The U.S. jobless rate currently sits at just 4.6%, and the Fed in its latest policy statement cited "the high level of resource utilization" as having "the potential to sustain inflation pressures."

The story we like to tell about labor costs is that when the economy grows too fast, unemployment falls and wages grow faster than productivity. This causes profit margins to fall a bit and prices to rise a bit (the relative strength of the two effects being determined by the strength of competitive pressures that prevent firms from passing cost increases on to consumers). In response to rising inflation, the Fed raises interest rates, which slows growth and puts downward pressure on wages. As the economy recovers, wage growth picks up, and the cycle repeats itself. The story predicts that periods of strong wage growth (a rising share for labor in national income) should coincide with periods of rising inflation. What does the data show?














At first blush (and that's all I'll give it here), the story seems to be true during the 1960s and 1970s: increases in labor's share in the late 1960s, 1974, and late 1970s coincided with rising PCE inflation, and in each case were followed by an increase in interest rates, recession, and decline in labor's share. Since the 1980s, however, I don't see a correlation. Labor's share rose in 1985-86 without a corresponding rise in inflation; labor's share rose during the recession-disinflation of 1990-91; and the dramatic increase in labor's share from 1997-2001 was accompanied by only a very small increase in core inflation. One reason may be the increasingly competitive environment businesses face, which forces them to reduce profit margins rather than raise prices when labor costs rise. So is the Fed's concern about labor costs misplaced?