How The Fed Can Bring About Higher Wages
Last Friday’s employment report provides further evidence of an accelerating economic recovery. More than 250,000 new jobs were created during December. Combined with upward revisions to previous months’ figures, that headline number brought total job gains for 2014 to almost 3 million. Meanwhile, the unemployment rate, which stood at 6.7 percent in December 2013, is now down to 5.6 percent—a sizeable and very welcome decline. These latest data combine with others from recent releases to confirm that 2014 was quite a good year for the American economy. And, as I argued in a previous column for Economics21, many encouraging signs suggest that 2015 will be better still.*
Sluggish wage growth continues to be a disappointing feature of the recovery, however. Unfortunately, this trend persisted, too, in last week’s report, which showed an outright decline in average hourly earnings for December and a disheartening partial reversal of November’s fledgling wage gains. Only when wages show more robust, sustained growth will the majority of Americans feel that our country is fully back on the right track. Economists understand, correctly, that while things are getting better, there is still a long ways to go.
Some commentators also suggest that this ongoing slow wage growth gives the Federal Reserve more time to wait before raising interest rates, on the grounds that price inflation is unlikely to rise without upward pressure on wages appearing first. To judge the merits of this argument, the graph below compares the behavior of wage growth and price inflation in the United States over the last half century. In the graph, nominal wage growth is measured by year-over-year percentage changes in average hourly earnings of production and nonsupervisory workers on private, nonfarm payrolls—these figures come straight from the monthly jobs report. Core price inflation, meanwhile, is measured by year-over-year percentage changes in the price index for consumer expenditures, excluding food and energy.
The graph shows something surprising. True, wage growth and price inflation did move closely together from the mid-1960s all the way through the early 1990s. Since then, however, the two series have decoupled; the previous close relationship appears to have completely broken down. This visual impression is confirmed by a series of more formal, statistics tests described in a recent report by Edward Knotek and Saeed Zaman, two economists from the Federal Reserve Bank of Cleveland. Using a variety of forecasting models, Knotek and Zaman discovered that wage growth lost most of its power to predict changes in inflation starting in the mid-1980s. The graph is also consistent with findings from earlier studies cited by Caroline Baum in another recent Economics21 comment on wages. This lack of reliable connections to inflation makes it very risky for Federal Reserve policymakers, or anyone else, to place too much faith in wage growth as an early-warning signal of inflation. The hypothesized relation just is not there anymore.
What explains the shifting relation between wages and inflation shown in the graph? This question demands further investigation, but one possibility is the changing behavior of inflation itself. When inflation is high, as it was during the 1970s, workers often succeed in negotiating for higher wages in anticipation that prices will continue to increase. To a large extent, however, these wage increases simply keep pace with the rising cost of living, providing no net gain to workers themselves. By contrast, in an environment with low and stable inflation, like we have enjoyed in the U.S. since the early 1990s, most wage increases are real—they outpace the slower rise in prices and translate directly into higher living standards. Thus, the figure shows that since the 1990s, real wage growth has been much higher, on average, than it was during the late 1970s and early 1980s. Since 1990, wage growth has also been strongly procyclical, accelerating during expansions and slowing down during recessions.
These most recent historical patterns should give us confidence that, as the economy continues to improve, more sizable wage gains will begin to accrue, bringing renewed prosperity to all Americans. These same patterns underscore that the best thing that the Fed can do right now is to stick to its current strategy of gradually but decisively bringing its monetary policy back to normal—a strategy that, most economists inside and outside the Fed agree, has to involve moving interest rates higher towards the middle of 2015. This will insure that inflation returns to its two percent long-run target without overshooting, maintaining the necessary backdrop of price stability that is required for a prolonged period of robust but sustainable growth. Experience shows that to bring about higher wages, monetary policymakers should focus on stabilizing inflation first.
* I would like to thank Charles Calomiris and Mickey Levy for extremely helpful conversations on the topics covered here, while emphasizing that all views and opinions are my own.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
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