Yellen Job-Slack View Muddied by Pent-Up Wage DeflationMatthew Boesler
Federal Reserve Chair Janet Yellen is raising questions about her own argument that stagnant wages mean the U.S. is far from full employment, armed with research from the Fed Bank of San Francisco that she used to head.
Yellen, speaking at the Fed’s annual symposium in Jackson Hole, Wyoming, last week, again cited low wage growth as evidence that the labor market is weaker than the 6.2 percent unemployment rate suggests and that interest rates should therefore stay low. And then she proceeded to cite reasons to be wary of that proposition.
Among them is a phenomenon dubbed “pent-up wage deflation” by researchers at the San Francisco Fed. During the recession and after, employers seeking to maintain employee morale refrained from cutting pay. That left wages higher than they normally would be after a severe downturn. As a result, employers now may not have to offer increases to attract workers as the job market improves, according to San Francisco Fed economist Mary Daly.
“We didn’t get wage deflation in the recession, and we are not going to get the gradual pickup in wage inflation as the unemployment rate comes down,” said Daly, who co-wrote a paper on the subject with her San Francisco Fed colleague Bart Hobijn. Instead, wage growth may stay low for a time, then pick up suddenly once the economy reaches full employment.
Daly’s argument may provide ammunition to some economists and Fed officials who say that the Fed runs the risk of being too slow to tighten monetary policy, inadvertently unleashing a burst of inflation. Yellen’s answer is that she and fellow policy makers are watching a wide variety of indicators.
Average hourly earnings rose 2 percent in July from the year before, matching the mean increase over the past five years and down from 3.1 percent in the year ended December 2007.
Yellen’s skepticism about the usefulness of wage growth as an indicator of labor-market slack reinforces her message that policy makers must look at a broad range of information to gauge how close the Fed is to reaching its goal of full employment, said Michael Feroli, a former Fed Board economist.
“You can’t just look at wage inflation to infer slack,” Feroli, now chief U.S. economist at JPMorgan Chase & Co. in New York, said.
Among the other indicators that Yellen watches are the participation rate, which measures the proportion of Americans working or looking for work, and the number of people working part-time who would prefer to have a full-time job.
The participation measure was 62.9 percent in July, down from 66 percent in December 2007 and close to the lowest since 1978. The number of workers employed part-time for economic reasons totaled 7.51 million in July, up from 4.62 million in December 2007, the month the recession began.
In July, the Federal Open Market Committee changed the language of its policy statement to highlight “significant underutilization of labor resources” as a justification for continued easy-money policies, even though the jobless rate has fallen faster than Fed officials had forecast. At 6.2 percent in July, unemployment was 1.1 percentage points below the level a year earlier.
“If pent-up wage deflation is holding down wage growth, the current very moderate wage growth could be a misleading signal of the degree of remaining slack,” Yellen said in her Aug. 22 speech at Jackson Hole. “Further, wages could begin to rise at a noticeably more rapid pace once pent-up wage deflation has been absorbed.”
That is how the data played out in the previous two cycles, according to Daly’s research. The recoveries that followed recessions in 1990 and 2001 were characterized by stagnant wage growth as the unemployment rate declined. It wasn’t until the economy reached full employment that wage gains began to accelerate.
“When you get to the point where you hit the natural rate of unemployment, you start to see wage growth come back up to its normal level,” Daly said in an interview. “So you might then go from 2 percent wage growth to something more like 3, 4, 5 percent wage growth, which is a normal level, more rapidly than you would expect.”
The result may be an unwelcome spurt of inflation as higher wages drive up consumer prices.
“The danger for the Fed is that they think inflation is under control, and then suddenly it’s not,” said Ethan Harris, co-head of global economics research at Bank of America Corp. in New York. “She is in an environment where there are serious concerns about the Fed falling behind the curve.”
That’s not a problem now. Prices as measured by the Fed’s preferred gauge rose 1.6 percent in June from a year earlier, less than the Fed’s 2 percent goal.
Harris said Yellen’s nod to the possibility of pent-up wage deflation is a sign that the debate is heating up inside the Fed about when it will be appropriate to begin raising interest rates above zero, where they have been since December 2008.
While the “labor market has yet to fully recover,” Yellen said in her Aug. 22 speech, the debate at the Fed is shifting toward when “we should begin dialing back our extraordinary accommodation.”
“As the recovery progresses, assessments of the degree of remaining slack in the labor market need to become more nuanced,” she said.
According to forecasts published at the conclusion of the Fed’s June meeting, most officials predicted the unemployment rate would fall to 5.2 percent to 5.5 percent in the longer run.
The question of whether there is more slack in the labor market than the headline unemployment rate measures may not be answered until it declines to those levels.
“I think we are probably going to need to see the unemployment rate drop into the low 5s, and I think you also need a general sense of confidence in the economy, that we are in a new phase of healthy growth,” Harris said. “And I think that will change the psychology of the worker and firm negotiation over wages.”