Recovery Is Nowhere Near Accomplished, and the Fed Shouldn’t Tighten Policy Until It Is
What follows are lightly edited remarks made by EPI Research and Policy Director Josh Bivens at a Dec. 9 event—Managing the Economy: The Federal Reserve, Wall Street, and Main Street—sponsored by EPI, Americans for Financial Reform, and the Roosevelt Institute Project on Financialization. Sen. Elizabeth Warren and Paul Krugman were the event’s featured speakers.
The event examined key policy questions facing the Federal Reserve in coming years. Bivens’s remarks focused on the need for monetary policy to allow a genuine recovery to happen, and argued that fears over coming inflation should not persuade the Fed to hike short-term interest rates before a full recovery is achieved.
I’ll begin by trying to frame why we think the topics being addressed by today’s panels and speakers are so important.
They’re important first because the economy remains far from fully recovered from the Great Recession. In fact, even after last month’s excellent jobs report, we’re still only about halfway recovered in terms of employment conditions, evidenced in the figure below simply by the share of adults between the ages of 25 and 54 with a job. If I had to pick one desert-island measure of labor market slack, this one seems pretty good to me.
The issues we’ll raise today are important as well because the Fed has been the only macroeconomic policymaking institution that has consistently and aggressively targeted a return to full recovery from the minute the Great Recession began, and in recent years they’ve faced historically large headwinds from other policymakers’ failures—particularly those of Congress.
Our fiscal policy at this point in the recovery has been radically different—and radically destructive to growth—compared with recoveries from essentially every other postwar recession. Let’s say this very plainly: If federal spending had grown after the Great Recession in line with the trajectories it followed after the recessions of the early 2000s, early 1990s, or yes, even the early 1980s when Ronald Reagan was president, we would have hundreds of billions of additional federal spending today and we’d be fully recovered from the Great Recession. Yes, the 2009 Recovery Act was a hugely important effort to break the back of the Great Recession and boosted growth for two years—but with the debt ceiling showdown and resulting Budget Control Act of 2011, we have throttled spending and economic growth to a very underappreciated degree. No, we haven’t seen Spanish or Greek levels of austerity, but we have seen historically unprecedented austerity in the context of our own economic history, as the figure below illustrates.
So, today, monetary policy is the only tool of macro stabilization we have going. And it’s actually a pretty weak tool when the economy remains sluggish even after the short-term interest rates controlled by the Fed have been stuck at zero for five years—call this condition the “liquidity trap.”
But, a weak positive effect is better than a powerful negative effect any day. And monetary policy is directed by Janet Yellen and Stanley Fischer, and not by John Boehner and Mitch McConnell—so at least we have the chance of evidence providing a valuable input into its setting.
And that’s part of what today’s panels are about, insisting that evidence—not vague conventional wisdom or outdated economic dogma—be the deciding factor in Fed decisionmaking.
There is a chorus of influential voices—including some regional Fed bank presidents—insisting that even monetary policy should join fiscal policy in slowing the pace of recovery by early to mid-next year.
The first rationale given for this is based on the old idea that the Fed must balance the benefits of more rapid growth and tighter labor markets against the prospect that these tighter labor markets boost wages so much that they push inflation past the Fed’s comfort zone.
The second rationale is that the Fed should raise interest rates because it’s the best way to ensure that financial sector risk-taking is reined in and bubbles are avoided.
Neither of these rationales makes a lot of sense.
The second panel will address the financial stability argument, so let me just say one word on the first rationale—that the Fed must get “ahead of the curve” in stomping out wage inflation before it gets running.
And that word is, “Seriously?” Wages have been rising for around 2–2.3 percent for the past four years, and there’s very little evidence of an upturn. And let’s put this number in some perspective:
Trend productivity growth is around 1.5–2 percent, and the Fed’s price inflation target is 2 percent. Wage growth of 2 percent combined with productivity growth of 2 percent puts zero upward pressure on prices—it’s wage growth consistent with 0 percent price inflation. Yes, hourly wages are 2 percent higher each year, but each hour of work produces 2 percent more output, so costs per unit of output are flat—there’s no price pressure at all.
So, if the Fed wants to target 2 percent inflation (which I’d argue is too low—but we’ll run with it for now), this means that wages should grow 3.5–4 percent in trend—almost twice as fast as they’re rising since the recovery began.
Further, the share of domestic income going to workers rather than capital owners plummeted in the early stages of recovery and hasn’t recovered at all. This means that we should see an extended period of wages rising well above 4 percent annually just to see the pre–Great Recession labor income share restored.
So, nominal wages, price targets, productivity, labor share of income—lots of stuff to juggle. We’ve tried to combine them all in the figure below.
Two lines. Actual hourly wages (in levels) and what these wages would be had they grown at the 3.5–4 percent target level we talked about before. The cumulative gap shows that today’s wages would need to grow faster than this 3.5–4 percent trend for a while to catch up to the pre-2007 trajectory—which is analogous to saying this is where they need to end up to claw back the labor share of income lost since then.
So, say they grow 0.5 percent faster than this target—4–4.5 percent. How long would it be before workers’ pay was back to its prerecession share of national income? More than 10 years. Ten years of growth as high as 4.5 percent—double what wages are growing today.
And yet people want to claim that labor market tightness and inflation is right around the corner and that the Fed should be restraining growth. Where can this belief possibly be coming from?
I’ll end with a couple of words on that—the other reason why the issues raised by today’s panels are important.
The overarching macro policy framework going into the crisis was that macro policy had basically collapsed to the idea that central banks should set a very low inflation target (2 percent—if you’re really austere, 1–2 percent) and that they had the power to enforce this target simply by controlling short-term interest rates.
What about the dual mandate and unemployment?
Not really a concern—but if you occasionally had to lower interest rates for a short spell to boost the economy that’s okay, but you really, really need to be careful because inflation is always looking to get the nose under the tent and really take off.
Today’s inflation hawks love metaphors like “you have to shoot ahead of the duck” and things like that. Metaphors are nice and all, but data and economic reasoning are better.
And our first panel is going to assess this overall policy wisdom about abandoning all tools except short-term interest rates for macro stability and see what applies today.
For somebody who lives in the D.C. policy world and thinks way too short term, the most important bit that needs reassessment from my view is the last: The evidence that wages are always looking to leap ahead of productivity growth and put huge upward pressure on the Fed’s inflation target is really, really thin.
How do I know this? Look for a second at the figure below, which shows what annual real (inflation-adjusted) hourly wage growth has looked like over the past generation—particularly for the bottom 70 percent of workers.
Does this look like wages as an irresistible force that needs to be constantly reigned in? To me, it looks like 70 percent of the American wage distribution seeing outright wage stagnation for 27 years.
And, yes, I did leave out a period—the figure below shows average annual real wage growth for the late 1990s.
This was the period when the Fed wisely did not allow metaphors about “shooting ahead of the duck” to trump the data showing no inflationary pick-up and allowed unemployment to fall all the way to 4 percent. What happened? Not irresistible inflation, but the only across-the-board wage growth in a generation.
There’s a lot at stake here. But we need to know that widespread wage growth requires very low rates of unemployment, and that the last generation of economic life really doesn’t support the idea that the Fed needs to be extra vigilant about fighting inflationary pressures. However, it does need to be extra-vigilant in not ending recoveries before they’ve done their work. And we need to figure out how to not let future recessions do so much damage for so long.
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