The Case Against Raising Interest Rates Before Wage Growth Picks Up
I’ve been arguing for the past year that until nominal wage growth picks up considerably, the Federal Reserve has little to fear about price inflation being pushed above its 2 percent target. The logic of focusing on wage growth is pretty easy to explain.
First, note that nominal (i.e., not inflation-adjusted) wage growth can rise as fast as economy-wide productivity without putting any upward pressure on prices. Say that both nominal wages and productivity rose 2 perecnt in a year. What would happen to the cost per unit of output? It would not rise at all. Hourly wages would climb 2 percent, but the amount produced in each hour of work—the definition of productivity—would also rise by 2 percent, so costs per unit of output (or, prices) would not budge. If we assume that trend productivity growth in the U.S. economy is roughly 1.5 percent per year, this means that only nominal wage growth faster than 1.5 percent puts any upward pressure on prices.
Now, the Fed isn’t committed to zero upward pressure on prices. Fed officials say they’re comfortable with 2 percent inflation. (I’d argue that they should be comfortable with inflation well above that, up to 5 percent, but we’ll take their target for now.) This price target means that nominal wage growth can be 2 percent higher than trend productivity growth before wages threaten to push inflation over the Fed’s target. We would need to see nominal wage growth of 3.5 percent, substantially higher than what it has been since the recovery began, before labor costs start threatening to push inflation beyond the Fed’s comfort zone. (There is a handy nominal wage tracker on the Economic Policy Institute’s website that covers a lot of this ground.)
All that said, in a speech last week, Federal Reserve Chairwoman Janet Yellen included a footnote that argued against the relevance of wage targeting. The upshot was this sentence: “More generally, movements in labor costs no longer appear to be an especially good guide to future price movements.” This footnote reinforced other recent statements from Dr. Yellen that seem to leave the door open to the Fed tightening well before any increase in nominal wages shows up in the data. I would argue that this is almost exactly wrong.
Here’s why I would say that it is only wage-driven increases in price inflation that the Fed should lean against with higher interest rates, while ignoring price growth resulting from other influences: The price of anything is the sum of labor costs (which are the outcomes of both nominal wage and productivity trends), producer markups (profit margins, essentially), and the cost of imported intermediate goods. Think of it this way: Every dollar you spend on something becomes somebody’s wage or somebody’s profit payment, domestically or overseas. So, rising prices must show up as increases in at least one of these flows: domestic wages, domestic profits, or spending on imports.
We know that rising import prices cannot be usefully addressed by the Fed raising interest rates. All else being equal, higher interest rates would lead to an appreciation of the dollar and a further rise in the cost of imports.
Further, evidence is clear that markups are at their thickest and rise fastest in the very early stages of economic recoveries, when still-slack labor markets have sapped workers of bargaining power needed to claim wage increases (see Figure G in this paper for some evidence across economic recoveries). Profit margins in the latest recovery rose steadily and rapidly between 2009 and 2012, yet nobody thought this was a signal that the Fed needed to sharply raise interest rates in those years.
Of the drivers of price growth, it is only labor costs that predictably begin to accelerate when the economy runs out of slack as recoveries proceed. Because of this, and because labor costs are by far the biggest component of overall costs economy-wide, these labor costs are what the Fed should be monitoring if it wants to keep price inflation stemming from excess demand-growth from going above its 2% target. And earlier in her speech, Dr. Yellen highlighted that the Fed tries to influence this degree of slack when making decisions about how to keep inflation stable:
Economic theory suggests, and empirical analysis confirms, that such deviations of inflation from trend depend partly on the intensity of resource utilization in the economy–as approximated, for example, by the gap between the actual unemployment rate and its so-called natural rate, or by the shortfall of actual gross domestic product (GDP) from potential output. This relationship–which likely reflects, among other things, a tendency for firms’ costs to rise as utilization rates increase–represents an important channel through which monetary policy influences inflation over the medium term, although in practice the influence is modest and gradual.
In the end, the prescription to hold off on interest rate tightening until there is a durable and significant pickup in wage growth still looks awfully solid to me.