Wage Growth Is the Key to ... Well, Everything
Call it the new Fed conundrum. 1
If the labor market in the U.S. is around full employment, as May's 4.3 percent unemployment rate would indicate, why are we not seeing surges in wage growth and labor-force participation?
The Federal Reserve's Open Market Committee laid out its most recent economic forecast in March. They forecast 2.1 percent real GDP growth in 2017, 2.1 percent in 2018, and 1.9 percent in 2019. All are modestly above the longer-run estimate of 1.8 percent growth. At the same time, the committee forecast the unemployment rate ending the year in each of those years at 4.5 percent, slightly below the longer-run estimate of 4.7 percent. When committee members made this forecast, the most recent data point they had for the labor market was a February unemployment rate of 4.7 percent, which, as we found out last Friday, has since fallen to 4.3 percent.
Based on the economic data we've gotten since the Fed's March meeting, their forecast has a problem. Starting from an unemployment rate of May's 4.3 percent rather than February's 4.7 percent means that the Fed is looking for two and a half years of above-trend real GDP growth coinciding with a slight rise in the unemployment rate. This would be an unusual turn of events. The economy has not behaved in that manner during the current economic expansion, which began in 2009.
How is it possible to get above-trend real GDP growth with a slight rise in the unemployment rate? One of two ways: an unexpected increase in labor-force participation, or a surge in productivity growth. Here's where wage growth comes in, because as the May jobs report shows, without stronger wage growth, neither is likely to materialize.
Some economists have argued that the labor market has more slack than is apparent from the unemployment rate. They point to an increase in labor-force participation over the past couple of years. It took until late 2015, but as Adam Ozimek of Moody's shows, tightening in the labor market did start to lead to an increase in peak-age labor-force participation. That reversed in May. While we should never read too much into any one month's data, it suggests the pace of the increase in labor-force participation might not be high enough to continue supplying the economy with an adequate amount of labor to continue growing above trend.
The other way to get above-trend growth would be an increase in productivity growth. But we have yet to see any evidence that this is happening. Through the first quarter, productivity growth remains stuck in its post- recession rut.
Stronger wage growth would solve all the puzzles perplexing analysts about the economy right now, and make the Fed's economic forecast plausible. How do we increase peak-age employment or participation? Stronger wage growth. What incentives would lead businesses to choose to invest in productivity-enhancing tools? Labor pressures on the bottom line brought about by stronger wage growth. What would cause profit margins to normalize from their historically elevated levels? Stronger wage growth. What's the most likely way to drive inflation fully back to the Fed's target? Stronger wage growth.
It doesn't take a PhD in economics to conclude that as supply goes down, price should go up. And an overwhelming amount of evidence suggests that the supply of available labor at prevailing wage rates has in fact gone down. Now, we wait for prices to respond. The Fed is counting on it.
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In the middle of the last decade, the Fed chairman spoke of its previous conundrum: While the government was raising short-term interest rates to cool off the housing market, longer-term interest rates (and mortgage rates) weren't going up at all. The Fed's ability to slow down mortgage lending was hampered by the "global savings glut," as investors worldwide were in a frenzy to buy American debt.
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