November 07, 2015
As the debate over a Fed interest rate hike heats up, it is worth noting an important distinction between the types of issues being debated. On the one hand there is a debate over what is likely to happen in a scenario in which the Fed soon begins raising interest rates and one in which it does not. On the other hand there is debate over what we want to see happen.
The first question has to do with the likelihood that we will see more rapid wage growth and more rapid inflation if the Fed holds off compared to a scenario in which it starts raising rates. Looking to the 1990s, many of us see the possibility that wages could grow considerably more rapidly without any substantial uptick in inflation. (There was strong real wage growth in the last year due to a plunge in energy prices, but no one expects that to be repeated. Real wage growth in the year ahead will depend on stronger nominal wage growth.)
Since productivity growth has been incredibly weak in recent years, the possibility of stronger real wage growth will depend at least in part on a return of more normal productivity growth, at least in the range of 1.5–2.0 percent. (Where are the robots when we need them?) There is a story that productivity growth may be in part endogenous. This would mean that in a tighter labor market firms have more incentive to economize on labor. Also, in a tighter labor market workers move from low paying, low productivity jobs to higher paying, higher productivity jobs.
There are clear differences among economists in their views on the extent to which a tighter labor market will first translate into higher wage growth, and secondly how much this will translate into higher inflation. However, there is also a difference on what we might want to see. There was a massive shift from wages to profits at the start of the recession. The weakness of the labor market allowed employers to keep pretty much all of the gains in productivity in 2008–2011.
This is a sharp departure from the rise in inequality that we saw in the prior three decades. That was pretty much entirely a story of redistribution of labor income. Money went from assembly line workers and retail clerks to doctors and lawyers, Wall Street bankers, and CEOs.
There was little shift in the division between wages and profits. While the Fed did not deliberately engineer the collapse of the housing bubble and the financial crisis that brought about this redistribution from labor to capital, it can try to take steps to undo it. That would mean allowing the labor market to get tight enough that wages could increase at the expense of profits to restore something like the pre-2008 labor-capital split.
Clearly, there would be more inflationary pressure in this scenario than in a scenario where the labor-capital split remains unchanged, but given that the inflation rate has been well below the Fed’s target of an average of 2.0 percent, there is plenty of room for some increase even if we believe the 2.0 percent target to be the right one. The importance of allowing a rise in labor shares due to a tight labor market depends on what we want, not what we believe about the economy.
Many of us see this return of labor shares to pre-2008 levels to be hugely important. To get an idea of its magnitude, we are talking about roughly 4.0 percentage points of national income. Since labor’s share of net income is currently just over 70 percent, this would imply an increase in compensation of more than 5 percent.
Is this a big deal? Suppose someone suggested raising the Social Security tax rate by 5 percentage points. We would probably see huge cries of outrage and predictions of the end of the world.
If we ignore the politics and consider the economic reality, a loss of 5 percentage points of wages due to a shift from labor to capital has the same impact on workers’ living standards as an increase in the payroll tax of 5 percentage points. If we think the latter would be a really bad thing for workers, then we should think that the redistribution from labor to capital in the recession was a really bad thing and want to see it undone.
This would mean that we should be willing to tolerate a somewhat higher rate of inflation and a bit of risk that inflation could go still higher. (Hey, there are no guarantees here.) But the alternative of having the Fed raise rates and prevent workers from gaining bargaining power is effectively to let corporate America impose a 5 percentage point increase in the Social Security tax.
Which side are you on?
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