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Slow Inflation: What’s the Wage Growth Tipping Point for the Fed?

April 4, 2016
How much inflation is enough? A look at wage growth and the Fed

Editor’s note: This is the second in a three-part series on paychecks and the Fed. Read the first.

The Federal Reserve is performing a delicate balancing act as it steadies the course of the U.S. economy. As inflation shows signs of what the Fed calls “stirrings,” the central bank must weigh that against wage growth—a key driver of inflation that hasn’t had any oomph—when deciding whether to raise interest rates. What does the Fed need to see in wage gains in order to reach an economic growth comfort zone?

To know that is to be a Federal Reserve mind reader—and if any of us were one, we’d quit our day jobs. But here’s what we do know about the minds of the Fed members, and in particular, that of Janet Yellen, its chair: She views wage growth as an oversize piece of the jumbo puzzle of a stable economy. Considering that median family income, adjusted for inflation, has dipped to $53,657 in 2014 (the latest numbers available from the Census Bureau) from $54,462 in 2013 and $55,987 in 2000, spending power is in a precarious state. That’s a problem. A big problem, because consumer spending is the engine of economic growth.

Get Rid of the Slack!

In a number of speeches over the last three years, Yellen has frequently pointed to wage growth, or rather stagnant wage growth, as a sign of slack in the labor market. In economics-speak, “slack” is the unused capacity in the labor market—how much machinery is sitting idle at plants, how many empty desks there are in offices, how many people want full-time jobs who don’t have them. It’s a difficult, if not impossible, measure to quantify.

Yellen’s not comfortable with slack in the labor market, and has said repeatedly that she wants to see it tighten before raising rates. “The labor market continues to strengthen,” she told reporters after the Fed held interest rates levels to 0.25% to 0.50% in mid-March. “But there’s still room for improvement.”

As of March, unemployment stood at 4.9%, just below the 5% range that the Fed targets as full employment. That’s certainly good news after the recession delivered stubbornly punishing 10% joblessness, but it isn’t convincing enough for the Fed. Besides, average hourly earnings have been flat in recent months and have grown by an anemic, seasonally adjusted 1.2% on a year-over-year basis, according to the Bureau of Labor Statistics.  

“I do see broad-based improvement in the labor market and I'm somewhat surprised that we are not seeing more of a pickup in wage growth,” Yellen told reporters in March, adding that this suggests “there is continued slack in the labor market.” Other labor market factors also imply that there are still plenty of people stuck in part-time employment looking for full-time jobs, she said.

The Inflation Quotient

Inflation, as measured by the Dallas Fed, is at 1.9%—its closest range to the Fed’s 2% target in more than two years. Consumer price inflation, as measured by the price index for personal consumption expenditures, climbed to 1.25% in the 12 months ending in January, according to the Fed. That’s partly because the deep falloff in energy prices that started in late 2014 was dropped out of the year-over-year calculations and no longer skewed the results.

Inflation is rarely good news to consumers, because as it rises, your purchasing power diminishes. But the Fed likes to see some inflation because it’s a sign of a healthy economy. When inflation is low, it can mean that the economy is not growing, which is what Yellen fears. If it’s too high, it can choke economic growth.

Why Does Wage Growth Matter?

Because inflation is growing at a quicker pace than wages, it’s in danger of putting the economy on a perilous path. No, it’s not quite the stagnation that crippled the nation in the late ’70s, but Yellen—who experienced that as a young economist—doesn’t want to go there ever again.

And let’s remember this: Wages power consumer spending, which accounts for two-thirds of the GDP. Without wage growth, the economic engine stalls.

Wage stagnation also suggests that paychecks aren’t enough to lift living standards to pre-crisis levels, says economist Diane Swonk, founder and chief executive of DS Economics. “Yellen … has argued that we will need to overshoot on both inflation and unemployment to regain ground lost to the financial crisis. She would like to see a more sustained acceleration in wages as well as a persistent increase in inflation before raising rates too aggressively.”

“Overshoot” is a relative term in this case. The Fed likes a little inflation because of its implications for economic growth, and it likes a little unemployment because it can lead to higher productivity per employee, but too much of either is never a good thing.

When Is Wage Growth Enough?

And that’s the $64 million question. Under historical economic thinking, the Fed would be looking for wages to move higher by 3% to 3.5% to keep inflation at its desired 2% target rate. But with the way the recession decimated wages, very little is falling in line with history.

What’s more, there is plenty of discussion around wage stagnation being a victim of structural employment changes rather than economic ones. The San Francisco Fed, for example, blames this new phenomenon on a generational transition. In a recent study, it says that the millennials are replacing jobs held by baby boomers, who were commanding substantially higher wages when they retired.

“While wage growth typically rises as unemployment falls, this relationship has been muted in the current recovery,” according to the report. “Changes in the composition of the workforce propped up wages during the recession, despite a significant increase in labor market slack. As the labor market has recovered, this pattern has reversed.

“We find that cyclical components, such as the entry of low-wage workers to full-time jobs, have combined with secular components, specifically the exit of higher-wage retirees, to hold down recent measures of overall wage growth,” the report says.

It seems a little simplistic—how many millennials are actually walking into those senior-level positions, and at meager wages?—but the point is well taken, and it offers food for thought on the changing demographics of the workplace.

So just where is that wage/inflation tipping point? That’s for Chair Yellen and the Fed board to know, and you to find out.

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