Wages are a poor guide for monetary policy

Wages are a poor guide for monetary policy

For years, the US Federal Reserve steered monetary policy in part by wage growth: drive slack out of the labour market and higher wages, and therefore inflation, should follow. That led Wall Street to fixate on average hourly earnings each “jobs Friday” (when the Bureau of Labor Statistics releases the monthly employment figures).

But fishing for inflation in this recovery, the Fed has been using the wrong bait, reading the water incorrectly and getting no bites — a point driven home by business owners I spoke with at the Rocky Mountain Economic Summit on a trout ranch in Idaho earlier this month.

It has been a policy tied to the Phillips curve theory of a trade-off between wages and unemployment. But the problem with this is that no matter how many times the Fed revises down its estimate for full employment and no matter how much unemployment falls, wage growth remains lacklustre. Average hourly earnings growth finally exceeded 3 per cent last August, but has stagnated since.

There are a number of structural reasons for tepid wages, over which the Fed has no control. Any fisherman will tell you the perfect cast won’t help if the current flows too quickly.

Consumption patterns have shifted drastically over the past 70 years. In the 1950s Americans spent more on goods, and goods-producing sectors (manufacturing and construction) tend to be high-wage. Now a majority of our consumption is of services, and most services-producing sectors (such as retail, social assistance, and leisure and hospitality) are low-wage.

A global oversupply of cheap labour also suppresses earnings. The fall of the Iron and Bamboo curtains roughly doubled the global work force over the course of two decades, a pattern that continues as other developing countries such as India and Indonesia urbanise and industrialise. The internet has only expanded globalisation.

Other factors suppressing wages are more specific to this cycle. Workers in the gig economy usually earn less than those in full-time employment. And there has been a significant increase in market concentration over the past 10 years. As the late Alan Krueger pointed out last year at the Fed’s Jackson Hole conference, it is easier for companies to collude on suppressing wage growth when there are fewer companies competing for labour.

Demographics play a role as well. Most economists focus on baby boomers retiring and being replaced by less experienced, cheaper workers. A number of business owners at the summit noted that the millennials they hire — the largest segment of the labour market — are more interested in the community and experience at work than in making as much money as possible.

As with all things in economics, maybe the problem is partly one of measurement. The average hourly earnings data does not capture benefits such as days off or health insurance, nor the value employees put on things like flexible work hours or feeling a sense of purpose in a role.

Focusing on wages to guide monetary policy has also failed because the transmission mechanism between wages and prices is broken. Even if the Fed were reading the water correctly, it may be using the wrong flies.

Some wage growth and higher input costs from tariffs have eaten into company profits in this cycle, yet companies continue to opt for forbearance instead of raising prices. Various regional Fed presidents have told me in recent months that chief executives in their districts complain about margin compression but do not feel they can act.

It leaves the Fed a bit like the fisherman who can’t figure out which fly to use. If wage growth isn’t an effective beacon, what replaces it as a guiding star for Fed policy? And what would generate inflation? The Fed seems finally to have given up on the Phillips trade-off. So far, though, policymakers have no answers to the larger questions. And that leaves policy adrift.

The writer is a senior fellow at the Harvard Kennedy School

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