(Bloomberg) -- Something is happening in the U.S. economy. The question is what.
As the rate of U.S. price inflation finally breaks through 2 percent and unemployment has fallen to 3.9 percent and wage growth picks up, the Fed talks of ongoing rate hikes. Will a tighter monetary policy choke off a labor market recovery? Probably not. It turns out economists, forecasters and pundits don’t actually have a firm handle on the relationship between these variables.
Let’s consider a few mechanisms as to how monetary policy might affect labor markets, employment and wages.
It is generally recognized that major, sudden deflationary shocks damage employment. In those moments, the Federal Reserve should stabilize nominal purchasing power and cut interest rates to fight deflation and prop up employment. But 2018 is a less clear case.
How might price inflation and employment be related today?
One hypothesis is that tighter monetary policy from the Fed, combined with higher short-term real interest rates, limits credit to business, and that hurts job creation and wages. It’s not clear this hypothesis is generally true, as the Fed’s powers over real lending rates to businesses are limited. But let’s explore the hypothetical. Probably we would not want the Fed to be cutting rates and goosing up the supply of credit in a time of near-full employment. The Fed already has used significant asset purchases to lower some short-term interest rates, and a relaxation of that stimulus might make more sense.
Under a second and quite different hypothesis, known as the Lucas supply curve, higher price inflation means workers seek more hours and are more willing to take a job offer. The inflation makes nominal wages higher, and workers initially confuse this with higher real, after-inflation pay -- and so they wish to work more. That would mean inflation is good for employment.
The thing is, the Lucas supply curve has been in disrepute since the 1980s, mostly because of criticisms levied by Keynesian-oriented economists, including Lawrence H. Summers. The data indicate that workers just don’t respond that much to modest changes in their nominal wages.
A third hypothesis, from John Maynard Keynes, is that inflation stimulates employment by cutting the real cost of wages for employers. As prices rise, a lot of workers don’t receive corresponding raises, and those workers don’t realize their real, inflation-adjusted wage has gone down (“money illusion”). At the lower real wage, employers are more willing to hire those workers and employment goes up.
Two points are worth making about this claim. First, currently unemployment is relatively low and wage growth has remained sluggish. Even if the money illusion theory is true, is now the right time to be exploiting it? The Fed would effectively be keeping rates low to make real wage growth all the more sluggish.
Second, these days more and more economists, especially those with Keynesian sympathies, are insisting that higher legal minimum wages don’t lower employment much, if at all. If higher real wages don’t much hurt employment, we shouldn’t expect lower real wages to much boost employment. This “new wisdom” on minimum wages contradicts Keynesian labor economics and implies inflation won’t much boost employment, if at all.
So what does this all mean? People pounding on the Fed for the expected rate hikes ought to be much more agnostic. Commentators who suggest that tighter monetary policy might “choke off” wage growth don’t have a coherent model in mind. Outside of major crash situations such as 2008, the evidence does not tip very clearly in one direction or the other.
One thing we do know about inflation is that voters hate it. Economists sometimes treat this belief as irrational, assuming that workers in aggregate will get raises to compensate for the higher prices. This is true for many top performers, whose income growth would exceed inflation regardless. But a lot of other workers are concentrated in somewhat bureaucratic service-sector jobs, they have weak bargaining power, and their pay is not indexed to inflation. If the rate of price inflation is 4 percent rather than 2 percent, for many people that means their take-home pay is worth 2 percentage points less than it would have been under modest inflation.
That’s the most important political truth about inflation, and it is not wrong or immoral for the Fed to take it into account in setting monetary policy and keeping inflation rates relatively low. Economists also argue that inflation will “eat away” the real value of Americans’ outstanding debts and make them easier to repay — but that’s true only if wages keep up with inflation.
Most discussions about monetary policy aren’t about economic theory (properly understood) at all. Rather they are about blaming the system, as people feel a sense of outrage that somehow someone isn’t trying hard enough to fix basic problems. Most of the claims out there, when put under the microscope of reason, dissolve into a beautiful, brilliant agnosticism. How little we know.
©2018 Bloomberg L.P.