“Fake” Puzzles

They are Phillips-Curve related:

An extended run of modest labor market gains this year has produced little acceleration in wage growth or inflation, underscoring a puzzle that complicates Federal Reserve policy decisions looming in the months ahead.

One place some are trying to find a solution is in “demography”. An example from the San Francisco Fed:

  • Simply stated, new entrants to full-time work, whether they are entering for the first time, re-entering from periods of involuntary or voluntary non-employment, or moving from part-time to full-time work, are more likely to make below-average wages.
  • Counterintuitively, this means that strong job growth can pull average wages in the economy down and slow the pace of wage growth.
  • This is exactly what we have been seeing in recent years. As the labor market has continued to strengthen, many workers have moved from the sidelines of the labor force or part-time positions into full-time employment. The vast majority of these new workers earn less than the typical full-time employee, so their entry brings down the average wage.
  • This effect is even more pronounced than usual because of the large-scale exit of higher-paid baby boomers from the labor force. With so many of this generation still approaching retirement, the so-called Silver Tsunami will continue to be a drag on aggregate wage growth for some time.

A more natural place to search for the reason wage growth is low is to look at nominal spending (NGDP) growth. The chart below, which depicts a wage Phillips Curve, where the wage is an average of four alternative wage measures, shows that for low unemployment rates (u<6%), above and below trend wage growth has a clear correspondence with higher and lower NGDP growth.

However, despite all that, the Fed thinks the economy as at full employment, so that any additional drop in unemployment would trigger inflation (and higher wage growth).

The unemployment rate is a bad measure of the slack in the labor market. Some suggest that a better measure is the non-employment rate among prime age (25 – 54) workers.

This alternative version of the wage Phillips Curve indicates that there is still a lot of labor market slack, despite the low unemployment rate.

Note that the chart also shows that wage growth during the “low slack” period is “high”. So now, we have to ask: Is the “low slack” and not NGDP growth that drives wage growth. Maybe it is both.

We also can ascertain that “low slack” and high wage growth does not necessarily spell inflation. The chart below shows that inflation is low in both the “low slack/high wage growth” and “high slack/low wage growth” periods. It is even slightly lower in the “low slack/high wage growth/higher NGDP growth period.”

It appears that the Fed´s worry about the consequences of the economy being at “full employment” are misplaced. It could experiment with higher nominal spending growth, which would help reduce labor market slack and, through that effect, increase wage growth without simultaneously triggering an increase in inflation.

From the July FOMC Minutes, however, the “balance of power” Is still unfavorable to that “experiment”:

FOMC Minutes:

Participants commented on a number of factors that would influence their ongoing assessments of the appropriate path for the federal funds rate. Most saw the outlook for economic activity and the labor market as little changed from their earlier projections and continued to anticipate that inflation would stabilize around the Committee’s 2 percent objective over the medium term.

However, some participants expressed concern about the recent decline in inflation, which had occurred even as resource utilization had tightened, and noted their increased uncertainty about the outlook for inflation. They observed that the Committee could afford to be patient under current circumstances in deciding when to increase the federal funds rate further, arguing against additional adjustments until incoming information confirmed that the recent low readings on inflation were not likely to persist, and that inflation was more clearly on a path toward the Committee’s symmetric 2 percent objective over the medium term.

In contrast, some other participants were more worried about risks arising from a labor market that had already reached full employment and was projected to tighten further or from the easing in financial conditions that had developed since the Committee’s policy normalization process was initiated in December 2015. They cautioned that a delay in gradually removing policy accommodation could result in an overshooting of the Committee’s inflation objective that would likely be costly to reverse, or that a delay could lead to an intensification of financial stability risks or to other imbalances that might prove difficult to unwind.

“Most” plus “some other” still constitutes a majority, but that could change if their “expectations” don´t pan out.

Meanwhile, market indicators continue to point to monetary policy tightness. That is very clear following the March 2017 rate hike.


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