The biggest unknown in the world of monetary policy today is the amount of slack in the U.S. labour market.
Unemployment has been plummeting over the past few years as workers have exited the labour force, but inflation remains persistently low nonetheless, giving rise to the notion that there is more slack in the labour market than the drop in the unemployment rate suggests.
The answer to the question of which indicator — unemployment or inflation — is correct about the health of the labour market is key to unlocking the Federal Reserve’s next big monetary policy shift, and the mixed signals they are sending at the moment have sparked a heated debate.
Goldman Sachs economists Sven Jari Stehn and Jan Hatzius propose a simpler approach: the Fed should focus on wage growth as a primary input into the “reaction function” that dictates its response to changing economic conditions.
Why focus more on wage growth instead of inflation, or even the unemployment rate itself?
Ultimately, wages will respond to tightening labour market conditions, whereas consumer price inflation may not.
“Low inflation should be indicative of the size of the employment gap,” write Stehn and Hatzius in a report.
“This approach, however, relies on a tight link between slack and price inflation. And the experience of the last couple of years suggests that price inflation is not very responsive to the employment gap at low levels of inflation and seems to fluctuate quite randomly when we are in the neighbourhood of price stability. The behaviour of core PCE inflation between 2011 and 2013 is a good example: core inflation rose by a full percentage point during 2011 and then dropped by the same amount in 2013, without any compelling macroeconomic explanation.”
In fact, wage growth has been rebounding over the past year, even as consumer price inflation has slowed, as the chart shows, and in the past, the former measure has offered a better reflection of the state of the labour market.
“Wage inflation was low in the early 1990s, early 2000s, and the period since 2008, when the economy really had a lot of slack; and it was high in the late 1990s and mid-2005, when the economy was at or beyond full employment,” say the Goldman economists.
In the report, Stehn and Hatzius devise a model to test whether an increased focus on wage inflation would lead to better Fed policy outcomes.
Their findings: the wage growth focus could help the Fed steer clear of policy mistakes in the future.
“While such a policy is not perfect — because the wage inflation process, too, is subject to uncertainty — the error band around the paths for the funds rate and unemployment rate is lowered significantly and more so than in the case of increased focus on price inflation,” they write.
“The intuition is simple: because the wage inflation process is more stable than the price inflation process in our estimated model, the former provides a better cross check of labour market slack and thus there is a stronger case for Fed officials to focus on it.”
Janet Yellen will make her first public appearance as Fed chairwoman on Tuesday in a congressional testimony. Most expect her remarks to be carefully in keeping with the Fed’s January statement detailing its latest decision on monetary policy.
However, down the road, an increased focus on wage growth could become a hallmark of the Yellen Fed.
“Although we do not think that the recent weakness in the data — and in nominal wage growth — is sufficient for a pause in the QE tapering process, we expect Yellen to indicate that more and broader labour market improvement is needed before the FOMC will consider an increase in short-term interest rates,” say Stehn and Hatzius.
“And our analysis suggests that one of the key markers for this is a faster pace of nominal wage growth.”