(Bloomberg View) -- Federal Reserve officials must think that something soon has to give in this economy. The current equilibrium, characterized by low inflation, low unemployment, low wage growth and high corporate profit margins, isn’t sustainable indefinitely, but they don’t know how or when it will crack.
The July consumer price inflation data did not exactly support the Fed’s position that another interest-rate hike this year and three in 2018 are necessary to keep the economy from overheating. It becomes increasingly difficult to argue that inflation is being held down by transitory factors when each month’s data delivers another new factor.
The Fed can always fall back on the unemployment rate to claim that although inflation is low now, it will creep back up to its 2 percent target with the economy operating at full employment. The minutes of the July FOMC meeting made clear that central bankers remain committed to this Phillips curve framework. Although persistently low wage growth calls that claim into question, the Fed has good reason to believe wage growth will soon accelerate.
To understand why, note that there is no single wage measure. We have a number of different compensation metrics. Obviously, using the “best” or “right” measure would be optimal, but in the absence of such knowledge, I created a composite based on the average of some common compensation measures:
With this measure I created a Phillips curve for wages. You can see that the current spot on the curve is an outlier:
The Fed’s relative confidence that the economy is operating at full employment is not unreasonable. If recent data are historical outliers, then wage growth will jump sharply higher -- and probably soon if unemployment keeps pushing lower. The Fed can always fall back on the lower productivity argument to support its contention that the economy is at full employment. New York Federal Reserve President William Dudley recently said:
Wage growth has also been comparatively modest even as unemployment has declined. In part, this likely reflects the fact that productivity growth has been sluggish compared to historical experience.
Dudley is correct. Low productivity alone does not appear sufficient to fully explain low wage growth. This can be seen if I adjust the above wage measure for inflation:
Even if the economy transitioned from a high-productivity regime in the 1990s to a low-productivity regime now, wage growth looks like it broke too low in 2016.
So what does this all mean moving forward? There are three possibilities:
- The Fed’s anticipated scenario: In this view, the economy is at full employment and wage growth will soon pick up. Firms are able to pass higher wage costs on to consumers such that the hit to profit margins is minimal. The Fed looks to stabilize the unemployment near current levels by raising interest rates as outlined in the June 2017 Summary of Economic Projections. As long as the Fed doesn’t push the economy into recession, equity prices move higher.
- The low-productivity scenario: Wage pressures grow as expected, but firms cannot pass on the additional costs. Either inflation expectations are anchored too strongly at something less than 2 percent or global forces keep downward pressure on costs. Moreover, the economy remains in a low-productivity regime. This situation implies a very flat Phillips curve, and the Fed should slow the pace of rate hikes. Lower margins would slow or stall equity price gains, another reason for the Fed to go slow as it would be less concerned about financial instability.
- The high-productivity scenario: Wages rise, perhaps sharply. But in a perfect world, firms can absorb much of the increase though higher productivity. Corporate profit margins stay high. The Fed might initially keep rates low until inflation reaches the target (I discuss here how the Fed should experiment with this approach), but higher productivity implies a higher estimate of the neutral interest rate. A higher neutral rate will likely place downward pressure on equity valuations. This implies earnings growth outpaces equity price gains.
Scenarios two and three imply the economy operates like the regime-switching approach advocated by St. Louis Federal Reserve President James Bullard. He would argue that the economy remains stuck in the low regime and that the Fed should resist raising rates until the economy flips into the high regime. If Bullard is correct, then the Fed’s pursuit of the first scenario places the economy at greater risk of recession. They would be operating under the wrong model and inclined to raise short-term rates too aggressively. This represents the greatest danger to the expansion and equity prices, but the threat is fairly distant.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.
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