Real Wage Growth vs. Embedded Inflation

Over at Mark Thoma's site, Fed watcher Tim Duy argues that policies aimed at accelerating real wages are likely to embed inflation:

Funny thing is it appears if we want to pursue Krugman’s policy of real wage acceleration, we will have to push up wages to compensate for the recent acceleration in wages, which sounds an awful lot like embedding higher inflation expectations into wage expectations. I imagine it would be something of a delicate task to shift compensation power to labor while convincing firms not to respond to that shift by hiking prices. The risk is that guaranteeing against a 1970’s repeat requires accepting a lower standard of living for the many Americans who have already seen virtually no gains since 2000, and this will become increasingly politically unpalatable in the months ahead. I am at a loss to see the expenditure switching policies that smoothly redistribute income (profits to wages) with out boosting aggregate demand in an environment that is already potentially inflationary. Suggestions?

A sharp decrease in gas prices is the only thing I can think of that would allow real wage acceleration without running an unacceptably high risk of embedding inflation. The key is managing inflation expectations -- if workers and businesses think the Fed will quickly tame inflation, then workers can make wage demands based on real wage acceleration rather than inflation. As this chart shows, inflation expectations are volatile, so a sharp decrease isn't out of the question:


A sharp decrease in gas prices is the best way to quickly temper inflation expectations. Gas is still a relatively large share of household consumption, and the price of gas is by far the most noticeable price of any consumer good (what with gas prices being posted on every street corner and all). If gas prices dropped, people would be much less worried about inflation. I don't think there's actually a policy we could implement that would sharply lower gas prices on demand. We need to get lucky.

Of course, lowering inflation expectations to the point where workers demand only moderately higher wages will only accomplish real wage acceleration if the Fed actually delivers the goods. If we convince workers that the Fed will tame inflation so that they won't base their wage demands on inflation, then the Fed actually has to tame inflation, or real wages won't accelerate at all.

This is a complicated scenario, and I'll be the first to admit that it's not likely to happen. But it's at least conceivable.