Real Output and Unit Labor Costs as Predictors of Inflation

Two popular inflation indicators commonly monitored by analysts are the pace of real economic activity and the rate of growth of labor costs. It is widely believed that if the economy grows at a rate above its long-run potential or, if the rate of growth of labor costs exceeds the trend rate in labor productivity, then inflation will accelerate. These beliefs derive from the “price markup hypothesis” implicit in the Phillips curve view of the inflation process. This view assumes that prices are set as a markup over productivity-adjusted labor costs and that they are also influenced by demand pressures. It assumes further that the degree of demand pressure can be measured by the excess of actual over potential output (termed the output gap). Thus, the Phillips curve view of the inflation process implies that past real output (measured relative to potential) and past growth in labor costs (adjusted for the trend in productivity) are relevant in predicting the price level