Sectoral wage growth and inflation

Most mainstream macroeconomists believe that the price of forcing the unemployment rate permanently below the natural rate of unemployment for a prolonged period of time is ever-increasing inflation. If this overheating occurs, the conventional wisdom is that the inflation rate can be reduced to more acceptable levels only if one endures a difficult recessionary period during which the unemployment rate exceeds the natural rate. In the parlance of economists, there is a vertical long-run Phillips curve that limits the ability of policymakers to independently affect both the rate of inflation and the unemployment rate. In the short run, the Federal Reserve may be able to reduce the unemployment rate below the natural rate, but in the long run the economy would revert to producing at its equilibrium level. The only lasting legacy of the Fed's actions would be to raise the level of inflation. The Federal Reserve has raised the federal funds target rate seven times since February 1994 in the hopes of keeping the economy from "overheating. " In doing so, the Fed has been attempting to walk the fine line of the long-run Phillips curve. This is no easy feat. It is more akin to a walk in the dark with policymakers feeling their way than to a stroll down a well-marked street. The main obstacle is the measurement of the natural rate of unemployment itself. If we could know the natural rate with certainty, the Fed's course of action would be clear: If the unemployment rate fell below the natural rate, the Federal Reserve would conduct a more restrictive policy; if the unemployment rate rose above the natural rate, the Fed would conduct a more stimulative policy. Unfortunately, the natural rate is not known and therefore must be estimated. There are as many different estimates of the natural rate as there are econometricians who estimate it. Furthermore, because these are just estimates, there is some uncertainty with respect to how confident we can be of these estimates. For example, a point estimate of the natural rate of 6 percent may easily have confidence intervals of [+ or -]1 percent - an uncomfortably large spread if one is trying to implement policy. To complicate matters further, the natural rate hypothesis is typically stated as a knife-edge phenomenon, that is, if unemployment is above the natural rate, the inflation rate would decline, while if unemployment falls below the natural rate, inflation would spiral out of control. In fact, both scenarios appear unlikely and simplistic. One can well imagine that as the unemployment rate slips below the natural rate, some industries, although not all, will experience difficulties in obtaining production inputs, including labor, at existing prices. As these shortages become more restrictive, input prices will be bid up and inflation will result. Only when these shortages become widespread at the existing price level will inflation result. The presence or absence of these shortages tells us a great deal about whether our assessment of the natural rate is accurate. If we believe the rate of unemployment is below the natural rate, then we should expect to see shortages and ensuing price pressures. If such shortages are absent. then our original assessment of the natural rate must be flawed. Absent such corroborating statistical evidence, we must reexamine our estimates of the natural rate. It is tempting to argue that rising wages in specific sectors are a precursor to widespread inflation. However, an analysis requires more than simply identifying the industries in which nominal wage growth is accelerating. Wages can increase for reasons other than inflationary pressures. For example, as workers become more productive, their wages naturally rise. Wages respond to sector-specific as well as aggregate factors. Wages in one industry may be increasing relative to another because of changes in the composition of product demand unrelated to inflation. Further complicating matters, even if some industries have high nominal wage growth unrelated to productivity growth, this does not necessarily foretell future inflation. …