How the Fed Misinterprets Wage Growth
Federal Reserve Chair Janet Yellen pointed to “nonexistent” real wage growth to justify holding rates at zero percent in 2014. There is room, she said, “for real wage gains before we need to worry that that is creating overall inflationary pressure for the economy,” suggesting that real wage growth was a precondition for rate hikes.
Fast-forward to today, and we find the Fed ignoring that dictum and in the midst of a series of rate hikes that are expected to continue, even with real wage growth back down around zero. Why the change?
To put it mildly, the Fed has demonstrated a clear misunderstanding of what drives real wage growth. As we pointed out in 2014, five of the six rate hike cycles since the late 1970s began when real hourly earnings growth was either negative or around zero. This is because inflation upswings, which are much larger, often overwhelm corresponding increases in nominal wage growth, reducing inflation-adjusted, or “real,” wage growth to around zero when inflation is on the rise -- both in 2014 and now. So the Fed has now dropped real wages as a concern but, like many others, is again misreading wage growth.
This confusion reflects a lack of understanding of the interplay between cycles in growth and inflation. Growth rate cycles consist of alternating periods of acceleration and deceleration in economic activity. When a growth rate cycle downturn culminates in contraction and the level of economic activity falls, that’s a recession. But if the cycle bottoms out without growth turning negative, that’s a so-called soft landing. Similarly, there are upswings and downswings in the rate of inflation, defining the inflation cycle. But growth rate and inflation cycles are distinct from each another, and are only loosely coupled together.
With the unemployment rate at 4.4 percent -- its lowest reading since May 2007 -- the Fed is anxious to raise rates because it expects such tight labor markets to spur too rapid a rise in wages, never mind that real wage growth is about zero. But the cyclical misunderstanding goes deeper.
Last fall, nominal year-over-year wage growth reached an 80-month high, which was widely seen as a sign of labor market tightness. But the Fed, along with most analysts, failed to recognize that this surge in nominal wage growth was largely the result of economic weakness.
The interaction of the two components of wage growth -- the growth rates of aggregate payrolls and aggregate hours worked -- illustrates why nominal wage growth can rise strongly during a slowdown. In a relatively tight labor market, where, during a slowdown, there’s a need to cut hours, labor market conditions make it harder to cut payrolls as much. Therefore, as hours growth falls faster than payroll growth, it actually boosts wage growth during a slowdown.
It seems the Fed was unaware of this dynamic -- most clearly evident in the cyclically-sensitive goods-production sector -- and welcomed the rise in wage growth, taking it at face value as a reason to start moving interest rates up.
Since September, as the economy has gained steam, we’ve seen the flip side of this dynamic. Labor market tightness had earlier kept payroll growth from slipping as much as hours growth, which has now rebounded more than payroll growth, pulling down nominal wage growth to a 15-month low.
Please note that this is a symptom of strengthening economic growth, not weakness or disinflation. In other words, in a tight labor market it’s logical to see nominal wage growth rising when economic growth decelerates, and falling when it accelerates. And it’s normal for real wage growth to plunge during an inflation cycle upturn.
Today the jobless rate is at its lowest point in a decade, while inflation has met the Fed’s 2 percent target. Having fulfilled its dual mandate, the Fed is likely to continue its monetary tightening, glossing over its Phillips-curve-driven misread of slackening nominal wage growth, and regardless of the absence of real wage growth.
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Max Berley at email@example.com