Janet Yellen, the US Federal Reserve’s chairwoman, gave an important speech earlier this month which raised several interesting issues. One of them was emphasised by the FT US economics editor Robin Harding in an article headlined “Yellen warns inflation may lag recovery”. In the April 16 article, he said that “Ms Yellen said that high levels of unemployment had put less downward pressure on inflation than expected, so higher employment might not pull prices up again”.
There are two diametrically opposite interpretations of the change in the relationship between inflation and unemployment to which Ms Yellen has drawn attention. It is either a one-off aberration which will unwind, or a structural change. If the former, then inflation is likely to remain low for longer than would otherwise be likely; but, if the latter, inflation is likely to pick up more quickly. The difference is crucial as the former interpretation would reasonably allow the Fed to delay raising interest rates, while the latter calls for an even earlier rise than would otherwise be appropriate.
I illustrate the way in which inflation has been higher than expected, relative to unemployment, in chart one below. (In order to ease the comparison in the way each series has changed, I have inverted the scale on the right). Over the whole period inflation has fallen much less than unemployment has risen, but the volatility of inflation provides scope for both optimists and pessimists. The rise in inflation in 2011, despite the small fall in unemployment, stands out as discouraging as unemployment could provide grounds for optimism. However, Ms Yellen seems unimpressed by the latter. In the same speech she remarked: “To some extent, the [current] low rate of inflation seems due to influences that are likely to be temporary, including a deceleration in consumer energy prices and outright declines in core import prices in recent quarters.”
The question is therefore why inflation is not lower than it is given the rise in unemployment; the most obvious answer lies in the behaviour of profit margins. As chart two (below) shows, corporate profit margins measured before capital consumption (depreciation) are at an all-time high. Corporate output is divided between profits and labour. When profit margins are high, prices are high relative to labour costs. If profit margins today were at their average level of 31.3 per cent, then corporate prices would be seven percentage points below their current level relative to output and, as corporate output is 52 per cent of US gross domestic product, prices would be about 3.5 percentage points lower today than they are.
It is reasonable to expect profit margins to rise and fall in the opposite direction to unemployment, as competition is likely to be strongest when demand is weak and unemployment high. In fact, other factors seem to have overridden this and there was no apparent correlation between unemployment and profit margins from 1948 to 1997 (correlation coefficient 0.00). Since then, however, there has been an apparently perverse change, with unemployment and profit margins rising together as I illustrate in chart three (correlation coefficient 0.68).
The failure, to which Ms Yellen draws attention, for inflation to fall less than expected is thus reasonably attributable to the changed behaviour of profit margins.
As regular readers of this blog will by now be familiar, I attribute this rise in margins to the change in corporate behaviour which has resulted from the change in management remuneration. As there has, as yet, been no change in the way chief executives of quoted companies are paid, I see no reason to expect their behaviour to change, nor therefore expect profit margins to fall, at least in the absence of marked economic weakness.
Mr Harding has also drawn attention to another potential problem for the Fed. In the same speech which Ms Yellen gave to the Economic Club of New York on April 16, she claimed that she considered the long-run equilibrium level of unemployment to be 5.2-5.6 per cent, while Mr Harding wrote on April 20 that: “Most estimates put the natural rate of unemployment – the lowest rate an economy can sustain before inflation rises – at 5.5-5.6 per cent in the US.” In addition, he reports that recent research claims that the key is not the average rate, which includes the long-term unemployed, but short-term unemployment, which at 4.3 per cent is already at its long-term average level.
The overall impression is that the Fed is predisposed to risk a rise in inflation. While dangerous, this may prove correct. One aspect of Ms Yellen’s view should, however, worry investors. She foresees a return to the previous relationship between unemployment and inflation. She is thereby implicitly forecasting that profit margins will soon fall.
Falling profit margins could provide a huge boost to the US economy, provided that they did not result in other undesirable changes such as a fall in business investment. If, for example, margins fell back slowly over the next three years, the impact would be to reduce inflation by more than one percentage point a year.
That would not, however, be welcome to the stock market. Ms Yellen is thus being pessimistic about the stock market and optimistic about keeping inflation low. In the short term I am less pessimistic about the stock market. Stock market bulls want inflation to be long postponed and profit margins to remain high. Considerable mental gymnastics are required to hold both these views at the same time. However, I expect the demand for such gymnastics to be strong and produce its own supply.
This article has been amended since initial publication to say “higher employment might not pull prices up again” in the last sentence of the first paragraph