United States
The Minimum Wage Hike and the Economy
January 24, 2007

By David Greenlaw | New York

In recent days, the House of Representatives passed a bill that would raise the federal minimum wage from its current level of $5.15/hour to $7.25/hour. The hike would be phased in over the course of a few years. Specifically, the minimum wage would be bumped up to $5.85/hour sixty days after the legislation is enacted, then to $6.55/hour one year later, and finally to $7.25/hour after an additional year. While the bill could certainly still be altered as the process moves forward, it seems likely that something along these lines will eventually become law. After this increase is fully phased in, the minimum wage adjusted for inflation will be at its highest level since the early-1980s -- although still a bit below the levels seen throughout the 1960s and 1970s.  What might this mean for the economy?

About 1.5% of workers in the US earned the minimum wage or less in 2005, the latest year for which complete data are available (Note: some workers earn less than the minimum wage due to exemptions for teenagers during the first 90 days of employment and apprentices in certain occupations. Also, workers who receive a share of their overall compensation in tips can be paid below the minimum wage in many states. However, the wages of most sub-minimum wage workers are still directly tied to the specified minimum via a set formula). The share of workers who are impacted by the minimum wage has steadily declined over the past few decades. Still, the size of the proposed increase -- 40% over about a two year period -- is quite large and will add to the economy’s wage bill.

Just how large will the effect be? A $2.10/hour wage increase for the 1.5% of the work force at or below the current minimum wage implies a 3 cent add-on to average hourly earnings over the course of a little more than 2 years. Of course, those who currently earn between $5.15 and $7.25 will also be directly affected.  This group accounts for 5% of all workers.  On a weighted average basis, we estimate that the workers in this group will receive a nearly $1/hour increase over 2 years.  This adds another 5 cents to average hourly earnings. Also, there is likely to be a small amount of spillover to those who currently earn slightly more than $7.25/hour. We believe this is worth another 1 to 2 cents per hour of upside for average hourly earnings during the next couple of years.

However, there is a potentially important offset that must be considered in this calculation. At present, 29 states -- with an estimated 70% of the nation's work force -- already have a minimum wage that is higher than the current national mandate of $5.15/hour.  Moreover, many of these thresholds have been put into place since 2005 -- the starting point for our earlier calculations. Indeed, hikes to $6.75/hour or more in states such as New York, Ohio, Arizona and Washington were effective just this month. Other states have already enacted legislation calling for a phase-in of minimum wage thresholds that actually exceed the federal proposal. For example, an increase to $8 hour will be effective in California starting in January 2008. The bottom line is that we estimate the combined effect of the hike in the minimum wage at the federal government level, together with the phase-in of increases already enacted at the state level, will add roughly 0.2 percentage points to the growth in average hourly earnings over each of the next couple of years.

The impact of the rise in wage growth on inflation is dependent on a number of factors -- specifically, the accompanying effect on productivity growth, pricing power, inflation expectations, the share of labor in the overall cost of production, and the response of monetary policy. Some studies have found that productivity is positively impacted by a rise in the minimum wage (see Bernstein & Schmitt, “Making Work Pay: The Impact of the 1996-1997 Minimum Wage Increase” and Card & Krueger, “Myth and Measurement: The New Economics of the Minimum Wage”). This finding is generally attributed to factors such as reduced employee turnover and higher worker morale.  In our view, productivity may edge up a bit faster than otherwise while inflation expectations seem unlikely to be affected in any meaningful way. So, the impact of the hike in the minimum wage on core inflation is expected to be more modest than the effect on wage growth -- adding perhaps 0.1 percentage point annually to the core inflation rate over the next few years compared to what it otherwise would have been.

The impact of a minimum wage hike on employment has become a highly controversial topic.  While a negative relationship between the minimum wage and employment had long been a central tenet of mainstream economics, recent empirical analysis has challenged this assumption. From our standpoint, any negative impact on employment associated with an increase in the minimum wage might be relatively modest as long as labor market conditions overall are reasonably tight -- since the minimum wage hike may simply speed up an adjustment process that is already underway. For this reason, we believe that any negative fall-out on employment will not be noticeable.  However, there may be some risk of a greater deterioration in demand for low wage workers if the economy were subject to a negative shock at some point down the road.

News of a forthcoming hike in the minimum wage should hardly come as a surprise given the outcome of the November elections. Indeed, with the possible exception of legislation impacting the drug industry and oil companies, this is about the only identifiable shift in public policy that seems likely to become reality as a direct result of the election.  On balance, we expect the minimum wage hike to give both real wages and inflation only a slight lift, and to have a negligible effect on economic growth.

Mexico
Tortilla Turmoil
January 24, 2007

By Gray Newman | New York

It is not difficult to understand why soaring tortilla prices provoked noisy protests in Mexico in recent weeks.  After all, there is no staple that is more quintessentially Mexican than the maize tortilla.  What has been more surprising, however, has been the noise in Mexico’s interest rate markets, which reacted to the jump in tortilla prices as if the central bank’s monetary stance was about to change.  Indeed, some have argued that Banco de Mexico is now likely to hike interest rates in the coming months. We respectfully disagree.

First and foremost, the tortilla turmoil is largely a political, not an inflation issue.  There is no price in the central bank’s basket of goods and services as politically charged as that of tortillas.  The upturn in tortilla prices allowed the opposition to pit the Calderon administration along with agro-industrial interests against the wellbeing of Mexico’s poorest families, for which tortillas are often a mainstay of their diet.  We are not suggesting that tortillas do not matter in the calculation of Mexico’s consumer price index; after all, tortilla prices fall within the core calculation of inflation as designed by the central bank and have contributed to higher inflation readings in recent weeks than previously expected.  But we are arguing that the political outcry has been far greater than what we expect to be the ultimate impact on inflation and monetary policy. 

Second, what appears to have driven tortilla prices up is a set of micro issues related to corn and corn flour distribution in Mexico, far from the reach of monetary policy. Both Mexico’s giant tortilla companies as well corn flour distributors have been signaled in the local press as being responsible for hoarding stocks and pushing up prices. Others have argued that the problem came about due to inadequate handling of corn import quotas from the US.  In neither case is the central bank well-equipped to deal with the immediate issue — a classic supply shock — by adjusting its monetary stance.  In contrast, the 13-point plan announced by the Calderon administration on Thursday, January 18 should help to reverse the recent price pressure.

Third, the problem appears to be largely localized.  Aside from tortillas, a handful of other items appear to have been the principal contributors to higher-than-expected inflation.  Indeed, if we look at Mexico’s disappointing inflation result in 2006, the uptick was largely the result of an upturn in the non-core component.  And even within the core component, two-thirds of the uptick in 2006 relative to 2005 came from a handful of goods in the processed food category.

Neither wages nor inflation expectations have shown any significant moves.  This is not surprising, given Mexico’s recent history with supply shocks.  Faced with the famed jitomate scares in 2004, 2005 and 2006 and the chicken and beef supply shocks of late 2004 and early 2005, in each case the moves turned out to be transitory affairs with little relevance to broader price-setting.  That track record, in turn, should give the central bank a level of comfort that it did not have in the past.

Food to energy

There is, of course, a more worrisome backdrop to Mexico’s recent tortilla turmoil: the doubling of international corn prices as demand for ethanol has pressured corn supply.  This is a legitimate medium-term concern and one that the central bank has been monitoring during the past year.  Given the importance of corn as a feedstock for chickens, pigs and cattle, the feed-through to protein prices cannot be discounted.  This, however, stands in contrast with the much more abrupt and dramatic hike in corn flour and tortilla prices in Mexico in recent weeks.  The measures announced on January 18 should help to ease the tortilla bubble, which had been forming in recent weeks and which ignited the political storm. 

There is a real risk that ethanol demand for corn may continue unabated in the US.  After all, even if corn prices rise further and oil prices were to drop, calling into question the economics of ethanol production, I suspect that the run-up to the US 2008 elections and talk of reducing US dependence on foreign oil would keep the politics of ethanol production alive.  And if corn use for ethanol continues to rise, there is a significant risk that corn prices could begin to move with energy prices, setting off a disturbing trend that could complicate the work of both the Calderon administration as well as that of Banco de Mexico.  That, however, is much more of a multi-year issue.  In 2007, there is competing talk of a corn glut from increased production in Brazil and Argentina and possible weather-related risks elsewhere.

Bottom line

When inflation was running at 18% or at 28%, the inevitable supply shocks such as bad harvests which pushed up jitomate prices or sent tortilla prices soaring were hard to see.  In recent years, in contrast, with inflation running near or below 4%, the impact of the supply shocks have been inevitably magnified — a 0.5% move here or there is that much more apparent when inflation is running at 4% rather than 14% or 24%.  And while the central bank must remain vigilant to ensure that the jump in one price or another does not spark a broader move up in price trends, the recent experience of Mexico’s ability to deal with supply shocks suggests that the current upturn in tortilla prices is likely to subside with little, if any, lasting impact on the inflation and inflation expectations.  The political noise surrounding this issue has been great and the longer-term risks surrounding corn as a new source of energy should not be underestimated; however, I suspect that neither will force Banco de Mexico’s hand on interest rates in 2007.