The Fed May Not See It, But There's Reason for Optimism
Last week the Federal Reserve embraced a “new normal” of lower growth, inflation and interest rates, and significantly lowered its 2016-18 interest rate forecasts. All this despite relatively unchanged economic forecasts. So what changed? James Bullard, the president of the St. Louis Fed, laid out the shift in his thinking in an article on Friday.
Bullard’s pessimism comes from the same areas where others see reason for hope. He dwells on three conditions of the current economic cycle: the unemployment rate has fallen significantly, yet inflation has yet to break out; productivity growth during this cycle has disappointed; and while recession does not appear to be imminent, it could occur at any time.
There’s reason for optimism on all three counts.
On that troubling first point, there are actually signs that wage growth is responding to the lower unemployment rate. This gives hope that the traditional link between employment and inflation will hold -- with wages rising as the supply of available labor tightens. The Atlanta Fed’s Wage Growth Tracker, a better proxy for wage growth than traditional measures because it tracks individuals 12 months apart, ticked up to 3.5 percent in May, its fastest growth rate of this expansion, and on par with wage growth in early 2005. Additionally, many measures of inflation continue to pick up, with the notable exception of the Fed’s preferred measure of core PCE price index (personal consumption expenditures excluding food and energy).
The second reason for optimism that the U.S. could shift out of this sluggish “new normal” is that we’re just now entering the part of the cycle where firms have incentives to invest in labor-saving productivity. Early in this economic cycle, the economy had significant excess capacity, especially in housing and manufacturing. Firms made the sensible decision to put those assets to work, hiring cheap labor to do so, rather than invest in new capacity or productivity-enhancing projects. This led to several years of elevated corporate profits and subdued wage growth and fixed investment.
Now, however, labor market slack is largely gone, especially among the labor pool of less educated workers. Wage growth is outpacing economic growth. With the labor force of less educated workers continuing to shrink, having shrunk by almost 5 million since the end of 2007, it’s unlikely that labor market conditions for employers will improve any time soon.
This is putting downward pressure on profit margins, because most corporations have been unable or unwilling to raise prices to pass along higher costs. Falling commodities prices offset higher wage pressures for a while, but that adjustment is tapering off. It’s possible that producers will next have to invest in new projects or raise prices merely to maintain their current position, let alone to grow.
Finally, on the recession question, there are a couple reasons for optimism. As Laurie Goodman of the Urban Institute showed, every year of this economic cycle we have been running a housing deficit, with Americans forming households faster than the housing industry builds new housing units. This pent-up demand acts as a strong support of continued expansion. Also, with real interest rates negative on Treasuries up to five years and beyond, investors have a strong incentive to continue to invest in productive assets rather than accept inflation-adjusted losses in government securities. This is a big difference between this cycle and the last, when five-year real interest rates were over 2 percent in 2006-7 even while residential investment was collapsing and banks and households were about to embark on years of deleveraging.
Bullard’s argument is that the shift from the post-crisis regime to an “old normal” hasn’t happened yet, and it’s impossible to forecast if or when such a shift will happen, therefore policy makers should assume it won’t happen. This may be the right policy conclusion, but there are good reasons to believe the future will play out differently.
There’s evidence from history that labor shortages are what lead to productivity and economic growth. In “When the Levee Breaks: Black Migration and Economic Development in the American South,” authors Richard Hornbeck and Suresh Naidu discuss how an exodus of African-American agricultural workers from Mississippi to northern cities like Chicago following the Great Mississippi Flood of 1927 was the impetus that led flood-ravaged landowners in Mississippi to modernize farming techniques and coincided with the 1940-70 economic transition from the “Old South” to the “New South.”
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