The political economy of monetary policy response

In response to a call for wage restraint by Bank of England Governor, Andrew Bailey, Martin Sandbu tweeted an important question,

Why does the governor of the Bank of England encourage restraint in wage demands but not call for restraint in businesses’ attempts to protect their profit margins? Intellectual bias, ideology, greater resignation wrt price- than wage-setting, or something else?

As Sandbu writes in his column, Bailey said that “we do need to see a moderation of wage rises, now that’s painful. I don’t want to in any sense sugar that, it is painful. But we need to see that in order to get through this problem more quickly.”

Sandbu puts the issue in perspective,

The wage-price spiral depends on not one but two mechanisms: wage demands trying to catch up with price rises and price increases to pass on rising wage costs. Calling for wage moderation can only be read as an attempt — or perhaps a wish — to weaken the first mechanism. But what about the second? Theoretically, you can prevent a wage-price spiral by disabling either of its two links: workers’ attempt to protect (or increase) their real wage, or businesses attempt to protect (or increase) their profit margin or real return. In other words, you could prevent a terms-of-trade shock from creating domestic inflation by forcing business owners to take the hit from higher imported input prices (and wage rises enough to cover the related consumer inflation) in a compressed profit margin...

An instinctive focus on wage demands and neglect of profit margins echoes the eurozone’s obsession with “unit labour costs” (the wage costs per unit of output produced) a decade ago. Then, the perceived imperative was to boost “competitiveness”, but nobody ever looked at whether “unit capital costs” (which can be defined in an equivalent way) should or could be squeezed instead... In terms of the theoretical model, assumptions about how wages are determined have no lesser status than assumptions about how prices are set... A lower profit margin could, in theory, discourage investment, and a person could logically believe that less investment is worse than lower real wages... Over the past four decades, the labour share of national income has gone down in most rich economies, and the capital share has gone up (they have been fairly constant in the UK, however) — but investment rates have largely fallen rather than risen.

I am inclined to agree with his diagnosis,

My best guess is simply that there is a blind spot in most economic policymakers’ mental model of the economy. It is so ingrained to ask how wage demands affect inflation that it is easy to miss the equivalent question about margin and profit protection. This is, I suppose, ideological in the sense that it unwittingly frames the problem so that the plausible answer favours the interests of one economic class.

This reaction has its resonance in several other areas in public life and economics. Subsidies to the poor is bad and to be reformed, whereas fiscal concessions and investment credits to attract investments is great. Keeping borrowing costs low to boost investment is fine, but not so to keep debt servicing affordable for middle class and low income housing mortgage holders (it creates bubbles!). 

This brings us to the central issue here. Is inflation transient or persistent? I have blogged earlier on the debate here. What will be the future course of inflation is the most important question facing the world economy. 

Here is a small thought experiment. If the Fed believes inflation is persistent and steps in aggressively to raise rates and bring inflation under control, it's certain to bring the markets crashing down and also plunge the economy into a recession. Rates will rise and so too will cost of debt servicing, impacting fiscal balances across developed countries. But it will cool down the labour market and nip in the bud the nascent signs of a recalibration of profit distribution between capital and labour towards the latter. It'll in the process also contribute to asset value destruction. However, historically it's observed that post-recession, asset values recover much faster than labour markets.

Instead, if the Fed believes inflation is transient and navigates cautiously and prefers to do only the minimum without adversely impacting growth, it'll go for smaller and fewer rate hikes. This will perhaps not rock the markets and keep rates under control. Rates too will inch up gradually. But there is the big risk that it'll not be enough and inflation surges and stays at double digit for an extended time, bringing the risk of stagflation. 

I made a table of the possible reactions of all stakeholders to the two scenarios - gradual and limited tightening Vs aggressive tightening. 

The gradual tightening scenario appears to align the incentives of some of the important stakeholders, including the Democratic Party establishment and financial market groups. The Fed could use a mix of 25 basis points rate hikes and unwinding of the quantitative easing measures to keep shaping expectations. But corporate interests may join hands with the Fed to follow this course. It would end up killing two birds with one stone - tame wage pressure, and also calm the bond and currency markets. Is Andrew Bailey hinting in that direction?

However, given the strong urge within the ruling establishment to avoid a recession and also prevent the markets from popping, I am inclined to think that the former would prevail. Aggressive tightening in the form of the first off-cycle rate hike since 1994 or a 50 basis points hike appear unlikely. This is likely to remain so unless the bond markets react violently to emerging news on inflation etc.