As something of a addendum to my last piece, I wanted to follow up on the take-down of the inflation story by Ethan Harris of BAML as reported by Sam Ro at Business Insider. Harris’ argument is that there is plenty of slack in the labor market, so there is no reason to worry that wage growth-fueled inflation is just around the corner. Fair enough; I have always said that the ultimate test of the theory that labor markets were tight would be higher wages. The part I wanted to follow up on was this quote:
Moreover, even if wages do inch higher, we are a long way from the normal 3 or 4% rate that could start to create serious pricing pressure.
I think this overlooks an important point – the Federal Reserve has historically tightened policy at or before wage growth turns upward and the policy peak occurs when wage growth is hovering in the 4-4.5 percent range:
In other words, we don’t need to see wage growth high enough to create price pressures to trigger tighter monetary policy. Typically, the Fed is tightening policy ahead of higher wage growth. This, I think, is one reason to question the Fed’s stated policy path and also explains why the Fed would be hesitant to embrace a lower unemployment threshold. The fact that wages are rising while unemployment remains high is probably something of a puzzle to them, and lends credence to the stories that the labor market is currently affected by severe structural issues even though they see the same measures of labor market slack that Harris identifies.
So it is not that the Fed is currently behind the curve, but that the upturn in wage growth will make them worry that they will need to act to prevent them from falling behind the curve. It is also another reason why they want to extract themselves from QE as soon as possible; they want to be prepared to act quickly should they find they took an overly dovish view of the labor market. I think there is a lot of uncertainty regarding unemployment/wage/inflation dynamics at the moment, and that uncertainty is not making the Fed happy given the size of the balance sheet.
Also consider also Federal Reserve Chairman Ben Bernanke’s justification for expecting inflation to trend toward the Fed’s 2 percent target. From his press conference (emphasis added):
First, there are some special factors, such as health-care costs and some other things, that have been unusually low and might be reversed. Secondly, if you look at the fundamentals for inflation, including inflation expectations, whether measured by financial markets or surveys; if you look at growth, which we now anticipate will be picking up both in the U.S. and internationally; if you look at wages, which have been growing at 2 percent and a little bit higher according to many indicators—all of these things suggest that inflation will gradually pick up.
In short, although as Harris states we would not expect significant price pressures until wage growth accelerates further, wage growth is already at a rate that biases the Federal Reserve toward tighter policy (or, at a minimum, less accommodative policy). Even the current meager wage growth rate is used as justification to ignore the inflation trend and initiate a plan to end asset purchases. What then might be the possibilities for policy from even slightly higher wage growth?
This piece is cross-posted from Tim Duy’s Fed Watch with permission.