Three observations about current monetary policy (the last one is the most important)

June 21st, 2019 at 11:37 am

If you follow such things, you know that earlier this week, the U.S. central bank shifted its bias from patient waiting to a bias toward rate cuts. Here are three observations about this moment in monetary policy.

1. The market reaction has been interesting as bond yields have tanked while equity prices have climbed. Such a dynamic is not a mystery, as both movements reflect a dovish turn by both the U.S. Fed and the European Central Bank. Also, as has been the case throughout the expansion, low yields for fixed income investments can juice risk appetites for stocks.

But there’s also an ongoing argument between the two sides of the market, with the bond market more worried about global growth (and thus expecting bigger Fed rate cuts i.e., not just insurance cuts, but recessions cuts*) than equities.

If the bond market is right, there are two big risks afoot. One is that the stock market takes a big hit. That’s not infrequent in these volatile days, and trust me, my heart bleeds not for big selloffs. But if tighter financial conditions persist, that becomes another risk factor for growth. Which prompts the second risk: if the bond market’s expectations of significant rate cuts, say >150 basis points, is correct, we’d end up uncomfortably close to the dreaded zero lower bound.

ZLB risk was a big theme of the Fed conference I attended a few weeks ago in Chicago, and numerous papers stressed the benefits of alternative Fed policies, mostly QE. I found them moderately convincing but a) the funds rate is still the big gun, and b) I’m therefore more convinced than ever that if the next downturn is of any significant magnitude, the fiscal response will be the key determinant of how damaging it is to economically vulnerable people.

2. Just in case you were wondering, there’s still lots of room for real wages to rise, a fact that holds even if believe that we’re solidly at full employment. In fact, even more so if that’s your take. The reason is that labor’s share of national income is at an historically low level, as shown in the first figure below. And if we’re truly at full employment, the added bargaining clout of middle- and lower-wage workers should enforce this result. (This is the BLS version of this variable, which is more pessimistic than some other series, but they all show the same thing.)

Source: BLS

Put aside for a moment another important fact: wage growth hasn’t much bled into price growth for a while now. If you worry that full capacity labor markets will generate inflationary wage gains, consider that non-inflationary gains can be “paid for” by a shift from profits to wages, which also has the advantage of being somewhat equalizing (only “somewhat” because such aggregate shifts say nothing about how labor income itself gets distributed).

The figure below updates an estimate by Josh Bivens on how many years it would take for faster compensation growth to regain labor share. The “low” scenario is for slow real wage growth, 0-1 percent, which leads to little claw back of labor share. Steady real wage growth of 1.5 percent (“middle”) gets labor share back to around 2009 levels by 2025 and real wage growth of 2 percent gets back to 2007 levels by then.

Source: My analysis of BLS data.

3. Finally, and I’ll shortly have more to say about this, something very important–and under-reported–occurred in Fed Chair Jerome Powell’s press conference earlier this week. Numerous times, he referenced discussions at the Chicago “FedListens” conference on how important high-pressure labor markets are to people and places left behind in periods of slack. In my presentation at the conference, I stressed these points as well, adding that the flat Phillips Curve creates an opportunity for the central bank to maintain and prolong the benefits of full employment until the price data–realized and expected–solidly signal otherwise. From the perspective of accelerating inflation, high pressure labor markets must now be considered innocent until proven guilty!

I give Powell and the board a great deal of credit for engaging in these discussions and even more so, for elevating what they’ve learned in the echo chamber of the Fed’s public comments. The FedListens!


*I take this language from a recent GS Research note which is behind a paywall.

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6 comments in reply to "Three observations about current monetary policy (the last one is the most important)"

  1. Masud Mukhtar says:

    I really enjoyed the read.
    Something that’s been weighing on my mind for a long time: there’s always a constant battle against regulation when were talking about volatile innovative complex products like MBS and CDO’s.
    Do you think we need to lax the regulations on them or a full product restructuring needs to happen to mitigate high risk exposure?

  2. john says:

    Yet not cutting after everyone knows a mistake was made is keeping the foot on the brakes.

  3. Nick Estes says:

    Gee, doesn’t it strike you as odd that trillion dollar deficits are anticipated as far as the eye can see, and yet the bond market is predicting lower interest rates? Why? Because the Fed says that’s what it’s going to give us. See the broader significance of this? It’s completely inconsistent with “crowding out” and the whole IS-LM apparatus. Interest rates are not set by supply and demand in the money markets; if they were the deficits would be sending them upwards. They are controlled by the Fed (now by paying interest on reserves) because the supply of money from the government and commercial banks is infinite, at any interest rate structure the Fed determines is appropriate. This is a key ingredient in Modern Monetary Theory. The government can fund budget deficts with bonds or with bank reserves; it doesn’t matter. Either way, the Fed will be mostly determining the interest rates. There will be no hyperinflation and no crowding out unless the initial deficit is too big. How it is funded doesn’t matter and increases in either the national debt or the level of bank reserves don’t matter either.

  4. Ecaa says:

    Great read. So it appears that labour really has lost out during the recent expansion. Is there a reason why its bargaining position has deteriorated? Especially given, as you point out, that the labour market is at or near full employment.

  5. Benjamin Cole says:

    We need a couple generations of “tight” labor markets in America. That would be the best tonic possible.

    And please, wipe out property zoning too.

  6. Douglas Rife says:

    Below is a chart of after-tax US corporate profits according to the BEA (adjusted for capital consumption and inventory valuation) divided by nominal GDP. The chart ends in Q1 of 2019 and starts in 1947. That’s more than 70 years of data. What’s clear from the chart is for most of that time the profits share has mean reverted. Typically, profits surge after a recession because labor costs fall and so does the cost of capital due to the Fed lowering interest rates. Then, as the recovery progresses the profits share begins to again decline as workers finally get wage increases pressuring profit margins.

    The profits share started rising well above historical averages after 2000,, which corresponds to when the labor share began falling. This shows that the lost labor share has mostly gone to increase profits as share of GDP. And after the Great Recession ended the profits share has gone to new highs never before seen since 1947. It began to show signs of mean reversion in the last few years but then the recent huge corporate tax cuts sent the profits share up to near record levels once again. That’s visible as a large jump near the very end of the chart in 2018.