The Federal Reserve board will meet this week to discuss interest rate policy and its views on the state of the economy. It is unlikely that it will raise interest rates at this meeting, at least in part because it doesn’t want to place itself at the center of public discussion just before the election. However, many members of the Fed’s policy-making Open Market Committee (FOMC) will likely look to lock in a rate increase at its December meeting. It will be unfortunate if they succeed.
The argument of those seeking to lock in a December rate hike is that the economy is at or near its full employment level of output. In other words, we shouldn’t be looking to get the unemployment rate lower than its current level. The concern is that further reductions in the unemployment rate will put more upward pressure on wages. This, in turn, will translate into higher inflation.
If the Fed doesn’t act to head this off we will be soon looking at a wage-price spiral like we saw in the 1970s. In that decade inflation eventually reached the double digits. It was brought under control with a severe recession in 1981-1982 that sent the unemployment rate to almost 11 percent.
While no one wants to see the inflation of the 1970s again, there are good reasons for questioning whether this is a serious threat. The economy has changed enormously from the 1970s. It is far more globalized, which means that excessive price increases are likely to be quickly countered by a flood of imports.
Furthermore, there is much more flexibility in the domestic economy. Few industries today face the sort of regulation that airlines, trucking and other sectors were subjected to in the 1970s. In addition, the price indexing of wages and other contracts that allowed inflation to spread quickly has all but disappeared. Similarly, unions are much weaker today. There are downsides to all these changes, but they mean that the economy looks very different in 2016 than it did the last time we had a wage-price spiral.
But taking the issue a step further, at this point there is almost no evidence that we are even seeing the beginnings of a wage-price spiral. The most recent data on the core personal consumption expenditure, the Fed’s main measure of inflation, shows it has actually slowed slightly over the year. The same is true of labor compensation, even though there has been some shift from benefits to wages. If inflation is about to spiral out of control we should at least be seeing the beginnings of some pick up of inflation. In fact, we don’t.
The rate hike proponents look at the current 4.9 percent unemployment rate and argue that this is pretty much the best the economy can do. They argue that if the unemployment rate went any lower it would set the wage-price spiral in motion, even if the current unemployment rate is not already low enough to have kicked it off.
The counter-argument points out that even if the unemployment rate is relatively low, it is largely due to people giving up looking for work because they did not see much hope of finding a job. The percentage of prime-age (ages 25-54) workers who have jobs is still down by almost 2 percentage points (2 million workers) from its pre-recession level. It’s down by almost 4 percentage points from the peaks reached in 2000. From this perspective, we can do much better.
It is also worth pointing out that the additional jobs added from growth at this point will go disproportionately to those at the bottom of the income ladder. The people who will get jobs as the labor market tightens further will be disproportionately less-educated workers. They will also be disproportionately African American, Latino and especially African-American teens.
We know that many African-American teens are struggling in the economy at present. While policy types have developed programs to help this disadvantaged population, the easiest thing is to stop the Fed from following a policy where it raises interest rates to keep people from having jobs.
At this point, the trade-offs would seem to argue for more wait and see from the Fed. The potential gains from allowing the economy to continue to grow and for the unemployment rate to drop further are enormous. On the other side, we have some ill-defined risk of higher inflation. If somehow we fail to move quickly enough and we do see some modest acceleration in the rate of inflation the Fed can always head it off with rate hikes later. This doesn’t seem like a tough choice.