What a healthy US labor market looks like

A James Alexander post

Tim Duy provides an excellent summary  of the state of play in the US economy from last week’s data releases. While Duy lands on the side of caution in terms of rate rises he is still unsure about what the Fed is actually targeting. I don’t think Duy is cautious enough because the Fed should drop all ideas of rate rises in the future, and not just talk about delaying them. A neutral stance rather than their current stop-start tightening bias is most appropriate.

One of his charts shows wage growth over the last 20 years. I think it shows just how far the US has yet to go in terms of achieving a healthy economy that needs any monetary tightening. Back in the 1990s hourly wage growth was running at around a nominal 4%. The Atlanta Fed wage growth showing wage growth for those in work for at least 12m was running at 5% – the difference being that those in temporary or part-time employment often see less wage growth.

JA Healthy Lab Market_1

Looking at just the Atlanta Fed data itself,  there is a fascinating breakdown between different categories of employed workers. Particularly job stayers vs job switchers. A healthy labor market, from the point of view of labor, is one where there is a good degree of job switching. It is also healthy from the point of view of the economy in that it allows good nominal growth to do its magic.

JA Healthy Lab Market_2

A healthy labor market, a healthy economy

  • One where workers who perform less well (are less productive) than average or in firms of industries doing less well than average, see their nominal pay rise but by less than those doing better (more productive) than average or in firms or industries doing better than average.
  • In real terms those doing less well than average or in firms or industries doing less well than average will see smaller rises or even possibly small falls.
  • This is an excellent result as it allows relative winners and losers to emerge yet without compulsory job losses.
  • Productivity rises as those workers more productive than average or in firms and industries more productive than average do better. The result is real economic growth for all.

In the 1997-2001 period job switchers (those who were recognised as being more productive) did significantly better than average – and there was a productivity boom. Between 2002-2006 the weak recovery did not see this pattern repeated, although it was emerging by 2006 just as the Fed began to apply the monetary brakes. The story post 2008 is dreadful. Monetary tightness has prevented not only any significant nominal wage growth but also any healthy differentiation – and any productivity growth to boot. It is only in the last few quarters that there has been any signs of healthy wage growth and again the beginnings of some healthy differentiation – differentiation in wage growth between job-stayers and job-switchers that leads to productivity growth.

A potential tragedy versus a potentially healthy labor market

Yet what do we see? A Fed already intent on repeating its historic 2007-2008 mistake of tightening monetary policy when on the cusp of a healthy labor market. What a tragedy! No wonder economic populism came close to winning the Democratic nomination, has won the Republican nomination and may yet win the Presidential election. Elites reap what they have sown (see Brexit). Neglect nominal GDP growth at your peril.

Elusive guidelines

For some time the economy has been ‘playing tricks’ on policymakers, in particular those at the Fed, concerned with monetary policy.

For more than one year, they have been signaling that the beginning of ‘policy normalization’ (aka the first rise in rates) was imminent, but at each turn something happened to thwart their ‘desire’.

It´s interesting to note, in that context, the ‘bias’ in some of the research being done at the research departments of the Federal Reserve System. Some would indicate that the Fed should start the normalization process now. Others that it could still wait a while.

In the first category, the San Francisco Fed has just released a study downplaying the fall in inflation expectations provided by market-based measures:

A substantial decline in market-based measures of inflation expectations has raised concerns about low future inflation. An important question to address is whether the forecasts based on market information are as accurate as alternative forecasting methods. Compared against surveys of professional forecasters and other simple constant measurement tools, market-based inflation expectations are poor predictors of future inflation. This suggests that these measures contain little forward-looking information about future inflation.

Another, from the Richmond Fed, indicates that we´re in ‘overtime’, given that the natural (aka Wicksellian rate) has for “a long time” been higher than the market rate:

The natural rate of interest is a key concept in monetary economics because its level relative to the real rate of interest allows economists to assess the stance of monetary policy. However, the natural rate of interest cannot be observed; it must be calculated using identifying assumptions. This Economic Brief compares the popular Laubach-Williams approach to calculating the natural rate with an alternative method that imposes fewer theoretical restrictions. Both approaches indicate that the natural rate has been above the real rate for a long time.

Going in the other direction, Mark Thoma discusses the ZPOP measure of the labor market developed by the Atlanta Fed:

The Fed has a difficult job. It must assess how close the U.S. is to full labor force utilization, and how that translates into inflation risk. Both steps of that process involve considerable uncertainty. The Atlanta Fed’s new ZPOP measure attempts to provide additional clarity, but as the researchers acknowledge, this measure isn’t perfect. In the end, the Fed will always have to make its monetary policy decisions based on incomplete information about the economy.

The panel below extends the ZPOP chart of Thoma and the Atlanta Fed to show how the story could have been different (and we wouldn´t be unduly worried about what´s the best measure of inflation expectations, interest rates being below the ‘natural rate’ or what´s the better labor market indicator).

First off, the best thing would have been for the Fed NOT to allow nominal spending (NGDP) to tank! Since it did, the best thing would have been to crank it up at a higher rate, to try and get as close as possible to the original trend level path.

ZPOP

Don´t argue that was not possible, because if the Fed can ‘choose’ one level of spending it can ‘choose’ any. And look how it allowed NGDP to grow at a higher rate after the mistake of 2001/02. This time around, it stopped the rise in NGDP growth too soon!

The Fed has allowed the economy to remain ‘depressed’. And in a ‘depressed’ economy, the ‘gauges’ of performance (most likely) behave differently, and that´s causing a lot of anxiety.

Note: But there are the diehard RBCers, like Ellen McGrattan who write Monetary Policy and Employment:

 Neither conventional nor unconventional monetary policy has much of an impact on employment. What does? Factors that drive the labor-leisure decision.

Kevin Erdmann Writes One of the Most Important Blog Posts of The Year

A Benjamin Cole post

Kevin Erdmann, of blog Idiosyncratic Whisk, has written extensively and persuasively about housing costs and inflation, but lately topped himself when addressing wages.

Erdman in his Sept. 9 post, Real Wage Rates and Tight Labor Markets, takes a look at “quit rates,” and concludes quitters, probably better referred to as “job hoppers,” get higher wages. The quitters move into jobs in which they are more valuable to the employer.

So wages in general can rise, but productivity rises too. “This is why the relationship between real wage growth and inflation is not strong,” says Erdmann.

Erdman further ponders the scene, and concludes, “In any case, it seems as though the overwhelming factor for positive outcomes [for both business and labor] is stability. That seems to be associated with inflation rates in the 2% to 4% range. Stability will be related to low unemployment and low risk premiums. The risk to our economy of wage growth, if there is any risk at all, seems greatly overshadowed by the risk of business cycle instability.”

Yeah, you know, snuffing out an economic recovery to fight minor wage growth is a bad trade-off.

Erdmann notes that present-day wage hikes are below 1990s levels even yet, btw. I note that Q2 saw unit labor cost deflation, as measured by the Bureau of Labor Statistics.

The Frantic Fed

The Fed, as widely observed, seems to be in a heightened, frantic, even hysterical state of prissiness regarding the possibility that inflation might migrate back up towards its 2% target (which evidently even Fed Chief Janet Yellen forgets is an average target, not a ceiling).

Even worse, the empirical evidence that 2% is a good IT is seriously wanting. As I have oft-noted, from 1982 to 2007 in the United States, the average inflation rate in the United States (CPI) was just under 3%, and real growth just north of 3%.

Question

Q: Given the historical record, and the observations of Kevin Erdmann, what makes a 2% IT attractive to central bankers?

A: They can undershoot it and be close to zero, their real goal.

Conclusion

What if a 3% average inflation is a better central bank IT (let alone NGDPLT)?

Could the Fed ever alter its IT? Could the Fed go to an IT-band, such as that of the Reserve Bank of Australia?

Have American policy-makers and central bankers become so inflexible, so hidebound, so PC, that a moderate increase in the IT is not possible?

And if a moderate increase in the IT is not possible with independent central bankers, is independence a good idea?

More “feel-good” about the labor market

From Matt Yglezias:

As of this month, the unemployment rate is now lower than it was at any point during Ronald Reagan’s administration: (and shows a version of this chart)

Yglezias Reagan Obama_1

That said, the labor-force participation rate has fallen since Reagan’s day. That’s mostly about population aging — there are a lot more retired people now than there used to be — and a little bit about more people being in college, but that doesn’t fully explain it. The labor-force participation rate of “prime aged” men between the ages of 25 and 55 has been steadily declining for decades, and in the past 10 years the participation rate for prime aged women has fallen slightly as well.

I believe there´s something more going on. During the Reagan years, prime age participation was going up. Now, participation is way down.

Yglezias Reagan Obama_2

But look at the whole series. Prime-age participation appears to reach a ‘steady-state’ in late 1989 (around 84%). During the 1990-91 recession it drops a tiny bit, but quickly goes back to 84.

During the 2001 recession it drops a bit more, and while it ‘considering’ returning to 84, the deep 2007-09 recession intervenes and the participation rate falls strongly and shows no sign of moving back.

Yglezias Reagan Obama_3

The next chart shows the simultaneous behavior of NGDP. In the 2000 recession NGDP growth falters significantly but climbs back up strongly. The participation rate stops falling, but before it can return to a level closer to 84, NGDP growth first dims and then tanks. The participation rate slides to 81, and has remained stuck there for more than two years. Note that NGDP growth never went back to the previous much higher level, maybe constraining a pick-up in the participation rate.

Yglezias Reagan Obama_4

Nevertheless, it´s much more comforting to say the problem is “structural” and outside the purview of monetary policy. I don´t believe that´s wholly true!