I’m sure it’s no surprise that I’d like the Fed to announce later today that they’re holding rates steady and maintaining a pretty dovish stance. Inflation remains unthreatening, real GDP growth in the first quarter is likely to come in at <1%, and—the subject of this post—the typical (median) worker is only now getting a bit of a boost from the tightening job market. The last thing we’d want to do given these conditions is endanger that welcomed trend.
Though slack remains in the job market, as it has tightened, wage growth has picked up a bit, even at the median. The figure below shows the year-over-year growth rate of nominal weekly earnings, and the smooth lines, based on a model I’ll explain in a moment, cut through the jigs and jags, revealing a bit of upward mo.
The model predicts median earnings growth based on a labor market slack variable and two lags of the dependent variable. What about those bits at the end, where one wage forecast keeps going up and one flattens? Those are based on different assumptions of just how tight the labor market gets.
The wage line that flattens out at around 3.5 percent nominal growth by 2018 assumes that the job market gets to full employment (which, given the slack metric I used, accounts for not just unemployment but underemployment as well) by the first half of next year and stays there (Chair Yellen has named 3.5% as a target for average compensation, implying she views that pace as trend productivity growth + the Fed’s inflation target).
The wage line that continues to grow, hitting 4 percent, simulates a job market that’s even hotter, where the jobless rate is allowed to fall below what we think of as full employment. With this scenario, we’re basically simulating a labor shortage, which significantly lifts the bargaining power of middle-wage workers.
But wouldn’t that be inflationary?
Not so much, really. Research I’ve cited elsewhere suggests that the slope of the “Phillips Curve”—the correlation between slack and inflation—is flat right now, implying a low level of transmission from the tight labor market to prices.
In this spirit, the next chart shows the result of another modelling exercise, this time, predicting the growth rate of the CPI (Consumer Price Index) based on the same slack variable as the wage model, along with energy prices and an index for the dollar, as both of these factors predict overall price movements. As you see, predictions from this little model track the CPI pretty well.
The end of this figure shows inflation “firming”—slowly drifting upward—but at full employment, the CPI hits its target of 2.5 percent at the end of 2018. And remember, that target is an average, not a ceiling. As you see, it’s been missing to the downside, so it’s due for a walk on the wild-up-side.
The other simulation, where the Fed kicks back and lets the job market fall below full employment, has the CPI hitting 2.8 percent by the end of 2018. Slightly above target, but again, that’s as it should be, assuming (and here I’m donning the cloak of the central banker) that inflation expectations remain anchored around their target, meaning people expect them to eventually tighten and nudge price growth back to the target.
Obviously, this is all just modelling and all models are wrong. Still, these models are telling us something useful and plausible: tighter labor markets are delivering a bit of bargaining clout to middle-wage workers. In our age of inequality, full employment—and even fuller-than-full employment—are critical correctives to the skewed distribution of growth. Allowing these dynamics to proceed apace may generate some price pressures, but that too is as it should be given how weak inflation has been.
So let’s see what Chair Yellen and company have to say later this afternoon, but their right move, in my not-so-humble opinion, is to let this ballet play out as above.