The following is a slightly edited version of remarks delivered on an Economic Policy Institute teleconference on Friday, July 25, 2014.
Since the Great Recession began almost 7 years ago, the Fed has been the most proactive and the most effective macroeconomic policy-making institution both in attempting to end the recession and then subsequently trying to spur a full recovery. It’s been the most effective by far in the United States and almost certainly the most effective in the world. The Fed deserves a lot of praise for this stance and the economic evidence argues strongly that it should continue to prioritize boosting employment and spurring a full economic recovery. Specifically, this evidence indicates:
- The economy continues to have enormous amounts of productive slack—including in the labor market.
- Until this slack is taken up, wage-driven inflationary pressures just will not materialize.
- Wage and compensation growth will have to more than double to put significant upward pressure on overall price-growth in coming years—meaning that the Fed should be fully comfortable with nominal compensation growth as high as 4 percent over the next couple of years. This follows from the fact that trend productivity growth is roughly 1.5 percent so that 2.0 to 2.5 percent nominal compensation growth above 1.5 percent implies rising unit labor costs corresponding to 2.0 percent inflation, allowing for an additional to 0.5 compensation growth at the expense of historically thick profit margins.
The Fed is commonly described as being tasked with targeting more rapid employment growth and economic activity until the point that such rapid growth begins to spur accelerating inflation. The U.S economy is nowhere near the point where growth is rapid enough to spark accelerating inflation. Instead, we remain far from fully recovered from the Great Recession, and because of this, inflationary pressures just aren’t in the data.
A couple of quick data points:
- The share of adults between the ages of 25 and 54—prime-age potential workers who are very unlikely to have voluntarily decided to leave the workforce out of the blue in recent years—that are employed today remains 3.7 percentage points lower than the peak it reached in January 2007. This employment-to-population ratio, or EPOP, fell 5.5 percentage points between the 2007 peak and its 2010 trough, and only a third of this decline has since been recovered. That’s not zero progress towards recovery, but it’s not progress that’s rapid enough to leave one confident it’s going to be sustained with a substantially less accommodative Fed, and it’s certainly not progress rapid enough to worry about an overheating labor market and unleashing inflationary pressure.
- Core price measures that the Fed generally is tasked to monitor closely remain extraordinarily tame. One can argue that the Fed’s implicit core-price inflation target of 2 percent is too conservative, and I would certainly make that case, but for now we’re consistently missing this target on the low side. The “market-based” core deflator for personal consumption expenditures is averaging year-over-year growth of just 1.2 percent over the first half of 2014.
Finally, preliminary runs on wage-data that EPI will release next week in a paper by Elise Gould shows that there has been a notable deceleration in wage growth in the first half of 2014 relative to the first half of 2013. Basically, every decile in the wage distribution has seen nominal wage growth, that is not adjusted for inflation, of less than 1 percent over that annual period, except for the 10th percentile which saw less than 2 percent nominal wage growth. Real wage growth for every decile above the 10th has been negative and has been essentially zero for the 10th percentile. In short, evidence of inflationary pressures coming from a labor market with rapidly dwindling slack is just not in the data. Even high wage workers who face much lower unemployment rates than average are unable to achieve solid, or any, real wage growth.
The stakes of prematurely ending Fed support to boosting economic activity and employment are huge. A healthy labor market is an absolutely necessary condition to seeing wages and living standards rise for the vast majority of Americans, and the data show clearly we still do not have a healthy labor market.
So far, the Fed, and particularly Chair Yellen, has shown an admirable commitment to evidence-based policy-making and to not inciting inflationary phantoms. This commitment has strangely led to a lot of criticism from those insisting that inflation is actually just around the corner and always will be, and some of this criticism has even come from leaders of regional Federal Reserve banks, actors with some real potential influence. This criticism is ill-informed, it’s wrong on the data, and, if followed, it would do a lot of damage to working Americans.
No increase in the short-term policy rates should happen as long as the labor market and prices look the way they do, and Chair Yellen’s attempts to move peoples’ attention off of simple-minded unemployment rate triggers for interest rate increases are really welcome. Yellen has been clear that one needs to examine wage and price measures to assess remaining economic slack. This is exactly the right approach. And we can even highlight an obvious, quite conservative rule here: if underlying productivity growth is around 1.5 percent, this means that nominal compensation growth of 3.5 percent is consistent with the Fed’s overall 2 percent inflation target. So long as nominal compensation growth is below this 3.5 percent, labor market tightness is by definition not contributing to above-target inflation.
Further, a historical pattern in business cycles is that profit margins surge early in recoveries, and then fall back to more-normal levels as labor markets tighten and wages grow later in the recovery. This pattern has been on clear display so far in the recovery since the Great Recession: profit margins have reached levels not seen since the 1960s, and have shown very little evidence of falling so far. If this historic pattern of profit margins giving some way to wage-growth is to happen in the current recovery, this will require an extended period of nominal compensation growth (plus productivity) to exceed the levels consistent with the Fed’s inflation target—meaning that compensation growth of well over 4 percent for a period of time would be expected and welcome. In essence, the historically thick profit margins seen so far during the recovery provide an ample cushion against tighter labor markets and faster wage-growth from translating directly into accelerating inflation.
Finally, the other major tool of American macroeconomic stabilization, fiscal policy, has actually been severely counterproductive since the end of 2011 and has actually provided a large drag on growth and recovery. This drag has come largely due to Republicans’ successful use of debt-ceiling brinksmanship to lock in austerity policies since then. Given this large headwind (granted, the headwind is less powerful in 2014 than in previous years—but fiscal policy remains a drag), it is vital the Fed not abandon its attempts to generate a full recovery.