When Standards No Longer Apply

Way back in the day when I was first learning about inflation and where it comes from, the distinction that was highlighted was between core and headline inflation. I came to understand that headline inflation is driven primarily by relatively more volatile food and especially energy prices. I also came to understand that core inflation is driven by relatively less volatile wages and housing costs. Fundamentally very straightforward concepts, but time and technology has a way of shifting the sand under the feet of even the most fundamentally straightforward concepts. Prime example being the Taylor Rule, but that's another discussion for another day.

When reading the April 2018 edition of the Federal Reserve Bank of San Francisco's FedViews, I came across a chart that highlighted a nuanced distinction between the correlation between wages and inflation pre 1985 which had a factor of 0.946 versus post 1985 which has a factor of 0.289. The composition of inflation measures did not change from before 1985 compared to after 1985, so that leaves the determinates of wage growth. The period stretching from the late 1970s to the early 1990s was plagued by a combination of high unemployment and high inflation, otherwise known as stagflation. The macroeconomic shift that was occurring during that period was the death of the manufacturing industry and the simultaneous emergence of the service industry as the dominant sector in the American economy.

The Fed also began actively targeting inflation levels towards the end of the 1980s in response to the stagflation during the period. The thing that threw off the balance was the shift in the US economic base from manufacturing to services. Inflation metrics were based on baskets of manufactured goods even though labor trends and by extent inflationary pressures began/are leaning towards the services sector. Services typically require relatively less labor and productivity can be enhanced with capital investments in technology. This simply means that the cost of new technology has a higher weighting than the cost of labor in determining the final cost of providing a service.

Unfortunately for workers in service-based economies, technology tends to evolve exponentially while costs tend to fall in a linear fashion. The exponential growth in technological efficiency means more workers are being displaced everyday than the day before, while the linear drop in cost means overall cost-of-living is falling relatively slower than real incomes. In other words, the skillset of the typical American worker is becoming obsolete; their bargaining power for wages is diminishing while consumer prices are being driven by factors outside the purview of the labor pool, with the shortfall being covered by personal debt.

The world has evolved and unfortunately not everyone has been willing or able to evolve with it, specifically the Baby Boomer generation. Fortunately, the millennial generation was born and raised in times of uncertainty and constant change, so we are native to creative destruction and rebirth. This is what the world looks like when standards no longer apply. We've got it from here.