Some have taken comfort in the fact that inflation has not yet been built into wage growth as evidence that inflationary expectations have not risen. But I am less sanguine because research indicates that by the time we have statistical confirmation that wages are increasing at rates higher than the rate of growth of productivity, a persistent rise in inflation most likely would already be in train.

The currently high level of inflation, if sustained, might lead the public to revise up its expectations for longer-term inflation.  If that were to occur, and those revised expectations were to become embedded in the domestic wage- and price-setting process, we could see an unwelcome rise in actual inflation over the longer term.  A critical responsibility of monetary policy makers is to prevent that process from taking hold.
...
In light of the increase in upside inflation risk, we must be particularly alert to any indications, such as an erosion of longer-term inflation expectations, that the inflationary impulses from commodity prices are becoming embedded in the domestic wage- and price-setting process.

Problems in the measurement of labor costs may help explain the absence of a clearer empirical relationship between labor costs and prices.  Compensation per hour in the nonfarm business sector, a commonly used measure of labor cost, displays substantial volatility from quarter to quarter and year to year, is often revised significantly, and includes compensation that is largely unrelated to marginal costs--for example, exercises (as opposed to grants) of stock options.  These and other problems carry through to the published estimates of labor's share in the nonfarm business sector--the proxy for real marginal cost that is typically used in empirical work.  A second commonly used measure of aggregate hourly labor compensation, the employment cost index, has its own set of drawbacks as a measure of marginal cost.  Indeed, these two compensation measures not infrequently generate conflicting signals of trends in labor costs and thus differing implications for inflation.

Over the past decade, formal work in the modeling of inflation has treated marginal cost, particularly the marginal cost of labor, as central to the determination of inflation.²  However, the empirical evidence for this linkage is less definitive than we would like.³  This mixed evidence is one reason that much Phillips curve analysis has centered on price-price equations with no explicit role for wages.⁴

Problems in the measurement of labor costs may help explain the absence of a clearer empirical relationship between labor costs and prices.  Compensation per hour in the nonfarm business sector, a commonly used measure of labor cost, displays substantial volatility from quarter to quarter and year to year, is often revised significantly, and includes compensation that is largely unrelated to marginal costs--for example, exercises (as opposed to grants) of stock options.  These and other problems carry through to the published estimates of labor's share in the nonfarm business sector--the proxy for real marginal cost that is typically used in empirical work.  A second commonly used measure of aggregate hourly labor compensation, the employment cost index, has its own set of drawbacks as a measure of marginal cost.  Indeed, these two compensation measures not infrequently generate conflicting signals of trends in labor costs and thus differing implications for inflation.

 Interestingly, however, the system approach does not seem to forecast price inflation as well as single-equation Phillips curve models do. This weaker performance appears to reflect, at least in part, the shortcomings of the available data on labor compensation. The two principal quarterly indicators of aggregate hourly compensation are the employment cost index (ECI) and nonfarm compensation per hour (CPH). Both are imperfect measures of the labor costs relevant to pricing decisions. For example, the ECI's fixed employment and occupation weights may not reflect changes in the labor market, and the ECI excludes stock options and similar forms of payment. CPH is volatile, perhaps in part because it measures stock options at exercise rather than when granted, and it is subject to substantial revisions. Moreover, these two hourly compensation measures often give contradictory signals.

Another benign possibility is that labor markets may not actually be particularly tight. There are a variety of ways to estimate conditions in the labor market, and some of these don't suggest much in the way of inflationary pressures. For example, the Conference Board index of job market perceptions, which is based on a survey of households, suggests that labor markets are only very slightly on the tight side. Moreover, if labor markets were tight, this could be expected to show up in robust growth of labor compensation. Instead, some of the data present a different picture: for example, the employment cost index shows remarkably restrained increases of only a little more than 3 percent over the past year.

We look down the vector of inflation rates and with the exception of Venezuela and a couple of other countries, they're all single digit, indeed clustered in the area of 1% to 7%, annual rate. I don't recall ever seeing that. I'm too much aware of the fact that we always had some two or three economies which were verging on hyper inflation or were in very serious difficulty. We don't have that at this particular stage. And similarly because of that we have nominal long-term interest rates all in single digits. What this essentially tells us is there's an integration in the world economy, which I've argued elsewhere is a consequence of the very dramatic impact of the fall of the Soviet Union and its economic consequences in creating a very large increase in the number of previously low cost, somewhat educated workers insulated behind central planning being opened to the competitive markets, the effects of which have been extraordinary. In a sense we are on the way to, over the longer run, doubling the size of the labor force which is working in international, competitive markets. That has brought world unit labor costs down, brought inflation down and interest rates down.

We look down the vector of inflation rates and with the exception of Venezuela and a couple of other countries, they're all single digit, indeed clustered in the area of 1% to 7%, annual rate. I don't recall ever seeing that. I'm too much aware of the fact that we always had some two or three economies which were verging on hyper inflation or were in very serious difficulty. We don't have that at this particular stage. And similarly because of that we have nominal long-term interest rates all in single digits. What this essentially tells us is there's an integration in the world economy, which I've argued elsewhere is a consequence of the very dramatic impact of the fall of the Soviet Union and its economic consequences in creating a very large increase in the number of previously low cost, somewhat educated workers insulated behind central planning being opened to the competitive markets, the effects of which have been extraordinary. In a sense we are on the way to, over the longer run, doubling the size of the labor force which is working in international, competitive markets. That has brought world unit labor costs down, brought inflation down and interest rates down.

I've heard more than a few stories of shortages of highly skilled workers, but thus far the increases in overall compensation have been relatively moderate. Furthermore, firms often tell me that productivity gains have given them a great deal of flexibility to produce without generating cost pressures.

We often hear the assertion that rapid growth in wages is an important source of inflationary pressures. I do not subscribe to this view. As an empirical matter, wage growth is not a very useful predictor of future inflation. If anything, it seems to work the other way: inflation is a useful predictor of future wage growth.

Perhaps more important in the current environment, wages tend to rise with labor productivity. Productivity growth in the U.S. has shifted up over the past decade or so, and as long as that continues, we should expect to see a pattern of persistently higher wage increases. The important point is that increases in wages matched by productivity gains are not indicative of any inflationary pressure.

Should these recent trends in compensation and productivity continue, there is a risk that businesses may be under pressure to raise prices.  Although a risk, there are forces in play that may restrain increased labor cost pressures from contributing to a rise in inflation in 2007.  Some companies, for example, may absorb increased cost pressures through reduced profit margins rather than raise prices and risk losing valued customers.  

Let me add a footnote here regarding wage rates and the inflation outlook. Some observers have viewed robust wage growth as a cause of inflationary pressures; I do not share that view. We can have healthy wage growth without inflation as long as we see commensurate growth in labor productivity... I would note that the rate of growth of productivity shifted higher beginning in the middle of the 1990s, and while productivity is hard to forecast, I believe that reasonably strong productivity gains will continue and will warrant reasonably strong real wage gains. What would concern me – and we have not seen this as yet – would be a persistent increase in wage growth that was not matched by a commensurate increase in productivity growth. Ultimately this would result in higher inflation.

Even with the opening of some slack in the manufacturing sector and in homebuilding, labor markets generally seem to have stayed fairly tight, with the unemployment rate at only 4-1/2 percent. Although recent data indicate that labor costs were not rising as rapidly in 2006 as first estimated, labor compensation does appear to have increased more quickly over 2006 than over 2005. Last year's increase in compensation also appears to have outpaced overall consumer price inflation. That development in and of itself does not necessarily indicate an increase in inflationary pressures, especially if it represents a process in which real compensation begins to catch up with the rapid increases in labor productivity earlier this decade. What would be problematic would be a pickup in the growth of nominal hourly labor compensation that was passed through to prices over the next several quarters, or one that was not matched, over a sustained period, by a comparable pickup in the growth of productivity. Eventually, the resulting faster growth of unit labor costs would pose a serious threat to price stability.

One challenge is understanding what the various different wage measures are telling us about this dynamic process. Over the last several years, changes in compensation practices likely have caused these measures to send conflicting signals about labor costs. For example, the total compensation series, from the BLS's Employment Cost Index, has grown by roughly 3-1/2 percent per year over the last decade. Over the same time, the compensation per hour figure, based on the National Income and Product Accounts and reported in the BLS's productivity report, has grown by just over 4-1/2 percent per year. But in the decade and a half prior to 1996, each grew at nearly identical rates of around four percent per year.

One reason why the two series may have diverged is that pay practices have changed. The NIPA-based measure includes stock-option realizations and lump-sum bonuses, while the ECI total compensation measure does not. As you know, these and other forms of variable pay now have a more prominent role in compensation. Indeed, recent studies suggest that stock-option realizations account for about one-quarter to one-half of a percentage point per year of the growth in compensation per hour during the late 1990s.

[Fed members] have to pay more attention to wages.  And I'm hoping that Ben Bernanke will recognize this. 

The last report we got -- the Fed comes and testifies before both houses twice a year and they present a report, the Humphrey-Hawkins report.  And the last time, I was going through it as we were getting ready for the hearing.  There were 13 sections about this part of the economy, that part of the economy.
 
In 12 of the sections, they talked about the economy in real terms, i.e. adjusted for inflation.  They talked about the real increase in this and the real increase in that.  In every single case, they adjusted for inflation. 

Then they got to wages, and wages were not adjusted for inflation.  They talked about nominal, i.e. they made wages look bigger than they are.
 
I think the Fed could show a little more social sensitivity to this.  I'm hoping that they will.  I have no -- I mean, I think Mr. Bernanke has been reasonable.