Unit labor cost and inflation expectations… Japan

I posted in the morning a graph of unit labor costs compared to inflation and labor share (% change over year). There was a key insight. If someone was to stop and think, the insight is actually important. Sometimes important ideas get lost in a post. So this post is to make sure it is not lost.

ulc cpi ls

The insight is that unit labor costs (blue line) tend to follow inflation (red line) when inflation expectations increase, and tend to follow labor share (green line) when inflation expectations are low or falling. Sometimes it is in transition between the two.

There are many insights from this graph…

  1. Is deflation possible? It depends on labor share.
  2. Can Japan raise its inflation? It depends on labor share.
  3. Can labor share rise faster than inflation? It only happened once back in 1960.
  4. What if labor share rose faster than inflation? Would you get a rise in inflation expectations? Well, let’s look at Japan… (semi-annual data).

 japan ulc cpi ls 2

First of all, you can see that the growth rates of all 3 factors pushed into negative territory between 1998 and 2006. Falling unit labor costs pull down the inflation top limit. But then labor share popped into positive growth and inflation went positive somewhat after. Then the crisis hit.

As inflation fell in Japan since the 1970’s, unit labor costs followed labor share… as is to be expected with falling inflation expectations. And labor share growth rarely rose above inflation. In 2001, labor share growth rose above the inflation rate, but both were negative still.

But now we see that unit labor costs trended higher than inflation/deflation after the crisis. Inflation started to go higher, but has not returned to positive territory as of 2013 semi-annual data. It is hard to trust the data for labor share because it is flat-lined at 0% since before the crisis. But I would assume that it is trending close to unit labor costs.

The critical factor for the success of Abenomics is getting labor share growth to rise above the inflation rate on a sustained basis. I do not think it is happening so far.

Why is labor share declining in so many advanced countries? Part of the reason is China’s great comparative advantage of extremely low labor share. Japan was and is highly susceptible to that effect.