Good News for the Fed Wage inflation is beginning to turn up, but Yellen will still run the economy “hot.”

oming into to its March meeting, there was little mystery about what the Fed would do—nothing— but a lot of interest and a wide range of opinion By Richard H. Clarida about how it would communicate a decision to keep rates on hold. Speculation focused on three key communications:

n The “dot plot”—that is, the Federal Open Market Committee participants’ assessments of the appropriate policy rate Cover the coming years; n The balance of risk assessment; and n The Summary of Economic Projections for inflation, unemploy- ment, and NAIRU (non-accelerating inflation rate of unemployment).

The biggest surprise on Fed day was that the median of the dots now in- dicates only two more rate hikes for 2016, down from the four hikes in 2016 projected at December’s meeting. This had the effect of moving the Fed dot plot liftoff path for 2016 and 2017 closer to market pricing, but with the latter still well below the former. As for balance of risk, whereas in January the Fed said that it was “closely monitoring” global developments and was “assessing” their implications, in the March statement the Fed has apparent- The Magazine of international economic policy ly finished their assessment and now concludes that “global economic and 220 I Street, N.E., Suite 200 Washington, D.C. 20002 Richard H. Clarida is C. Lowell Harriss Professor of Economics and Phone: 202-861-0791 Fax: 202-861-0790 International Affairs at Columbia University and Global Strategic www.international-economy.com Advisor to PIMCO. He served as Assistant Secretary for Economic Policy [email protected] at the U.S. Treasury from February 2002 to May 2003.

44 The International Economy Spring 2016 Clarida

financial developments continue to pose risks.” The SEP projections now show somewhat less inflation Figure 1 The Fed wants to run the economy at least a little hot in 2016 and slightly less inflation in 2017 than was projected in December, and the median estimate 9 of NAIRU has shifted down by one-tenth of a per- centage point to 4.8 percent. What has attracted cent 8 somewhat less attention is that, notwithstanding , per te this downward adjustment to the NAIRU, the Fed 7 projects that its policy of increasing the Federal 6 yment ra Funds rate towards a “new equilibrium” destination at a “gradual” pace will continue to provide accom- 5 Unemplo modation sufficient to push the unemployment rate 4

2011 2012 2013 2014 2015 2016 2017 2018 Longer Run In other words, the Fed wants

3 to run the economy—at least

2 a little—hot and to keep the cent lation, per

1 unemployment rate “lower than PCE inf

the NAIRU and for longer” than 0 2011 2012 2013 2014 2015 2016 2017 2018 Longer Run is typical in Fed rate hike cycles.

Figure 2 pce inflation running below Fed’s target below the NAIRU later this year and keep it there through at least 2018 (Figure 1). In other words, the 120 00) Fed wants to run the economy—at least a little— 115 Jan. 2012: Fed formally adopts a 2 percent inflation target hot and to keep the unemployment rate “lower than 110 the NAIRU and for longer” than is typical in Fed 105 rate hike cycles. ed (2009 = 1 100 Given the initial conditions that Janet Yellen y adjust 95 Price level consistent inherited upon becoming Fed chair in February with 2 percent inflation 2014 and the Phillips curve lens through which 90 85 she and key members of the Committee interpret , seasonall

or PCE Price Deflator

the labor market, setting a policy path that will al- lat 80 low the labor market to “run hot” is an understand- 75

able choice. As shown in Figure 2, U.S. inflation PCE def 70 1 11 10 as measured by the PCE deflator has consistently 12 13 14 15 996 997 998 999 remained below the Fed’s 2 percent target since 991 992 993 994 995 Dec-20 Dec-20 Dec-20 Dec-20 Dec-20 Dec-20 Dec-200 Dec-1 Dec-1 Dec-1 Dec-1 Dec-1 Dec-1 Dec-1 Dec-1 Dec-1 Dec-2002 Dec-2003 Dec-2004 Dec-2005 Dec-2006 Dec-2007 Dec-2008 Dec-2009 that target was first announced in January 2012. Dec-2000 In the Fed’s model, holding constant expected Continued on page 75

Spring 2016 The International Economy 45 Neusser

phenomenon given what’s at stake? After all, Germany’s migrants government subsidies, these affluent elites alle- éminence grise in all things economic, Hans-Werner viate their guilt while burdening middle-class taxpayers. Sinn, said in a recent interview with Die Welt that from The tragedy is that these actions have helped neither the an economic perspective, the cost of border patrol migrants nor the countries from where they came. The agents is only a fraction of the cost of the migrants. migrants are stuck in an environment that they seeming- There are several reasons. Among the ruling elites and ly are unable to assimilate into. Their countries of origin their affluent supporters, there is a feeling of guilt for are left without an element of their population that could having amassed so much wealth and security in post- bring about change. After all, people who emigrate tend World War II Europe. In Germany, there is also the to be those who are comparatively more willing to act feeling among the ruling classes and their affluent sup- for change. porters that Germany needs to amend for the horror the Any solution to this problem would have to start National Socialists inflicted on the whole continent and with a halt to Muslim immigration. History shows that beyond. Some suggest these affluent citizens are bored governing elites are too often plagued with paralysis, and are looking for something that adds meaning to their even if they are aware of a pending catastrophe. One just lives and at the same time alleviates the real or imagined has to read Barbara Tuchman’s book The March of Folly guilt they feel over their affluence and over Germany’s to see how slim the hope is that government officials past. With this in mind, the migrants look like a means have the courage and foresight to avoid a looming disas- of making amends. By providing shelter—preferably ter—outright civil war. I hope my Austrian friend and I in middle-class or poor neighborhoods—and by giving are wrong. u

Clarida

Continued from page 45 inflation, the only way to get inflation moving up to the 2 TIPS market fell below their historic averages in 2014 percent target is for the unemployment rate to be pushed and have remained below those averages since then. By below the NAIRU. projecting a baseline policy path for gradual lift-off with A second motive for the Fed to run the labor market a Fed Funds rate trajectory that is lagging behind pro- hot is, I suspect, driven by the Committee’s concern over jected inflation throughout 2016 and almost all of 2017, the Fed hopes to steer inflation expectations higher by projecting a baseline scenario for lift-off under which real interest rates at the short end of the yield curve will Setting a policy path that will allow remain negative for at least two years. A challenge the Fed will face as it tries to engineer a “dovish” rate hike cycle is that investors, households, and firms are condi- the labor market to “run hot” tioned by experience to associate Fed rate hike cycles with efforts by the Fed to either reduce inflation or, as was the case in 1994 and 2004, to prevent inflation from is an understandable choice. rising above 2 percent. Chair Yellen herself expressed during her press conference some doubts about the up- ward momentum in core inflation, saying, “I’m wary and haven’t yet concluded that we have seen any significant recent declines in various measures of inflation expecta- uptick that will be lasting in, for example, core inflation tions which have not in recent years respected the “hold- … [However] with continuing improvement in the labor ing constant” assumption. For example, both the respect- market, I think we will see upward pressure on inflation.” ed Michigan survey of household inflation expectations In August 2014, I published an essay entitled “Share as well as break-even inflation rates derived from the and Share Alike” in which I reported and interpreted the

Spring 2016 The International Economy 75 Clarida

Importantly, this rise in labor’s share oc- Figure 3 Labor’s share of national income rising steadily curred before, and usually well before,

72 5 the business cycle peak and continued Labor Compensation Share as the economy fell into recession. The 71 of National Income (left scale) rise in labor’s share that occurs during 70 4 recessions is well known and is usually

69 attributed to the desire of firms to “hoard” labor initially in downturns as sales de- 68 3 Pe cline—holding off on firing workers until r cent cent r 67 the decline in demand is clearly expected Pe 66 2 to persist. What is less appreciated is the Core PCE Inflation phenomenon of labor’s rising share of in- 65 (right scale) come well in advance of the peak in eco- 64 NBER NBER NBER 1 Business Business Business nomic activity and for reasons unrelated Cycle Peak Cycle Peak Cycle Peak 63 (July 1990) (March 2001) (December 2007) to labor hoarding.

62 0 4 2 0 Bottom Line -1 -1 -1 -86 -88 -90 -92 -94 -96 -98 -00 -02 -04 -06 -08 -84 Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar So although it took a while to kick in, it does appear that this recovery from the Great Recession has returned to the pat- tern of past cycles in which labor’s share historical data on labor share of U.S. national income and of the pie begins to rise—and of course capital’s profit share documented the underappreciated pro-cyclicality of labor’s of national income begins to decline. These facts are worth share toward the midpoint of past economic cycles. At that remembering next time you see the anchors on financial time I wrote: television bemoaning sluggish gains in corporate earnings. Especially in a low productivity growth world, gains in la- Much commentary and public concern have focused on bor’s share will come, at least to some extent, out of profit the evident trend decline in the share of U.S. national growth. The extent to which this happens will of course de- income flowing to labor and the corresponding trend pend upon how much of the higher labor cost bill is passed rise in the share of U.S. national income flowing to cap- through to prices. The Fed wants higher inflation from to- ital… While it is too soon to tell if the current expansion day’s levels so it will not be inclined to run a hawkish policy will—like prior expansions—feature a rise in labor’s that would prevent it. That said, the Fed is always reminding share back toward the historical average, there is some us that 2 percent is a target, not a ceiling, and that it does evidence of an acceleration in wages that is beginning not want to run a policy that keeps average inflation below 2 to emerge in tandem with the ongoing decline in the un- percent. The SEP projections do not acknowledge a baseline employment rate. If and when labor’s share of national scenario in which inflation overshoots the 2 percent target income and wages rises and unemployment continues to fall, what will be the implications for inflation and, in turn, the Fed? As is shown in Figure 3, since I wrote that article in The Fed is always reminding us that the summer of 2014, labor’s share of national income has increased materially in tandem with the much more widely documented and discussed decline in the unemployment 2 percent is a target, not a ceiling. rate. As of the fourth quarter of 2015, it stands just north of 67 percent, reaching a share last observed (on the upswing) in December 2006. Note that this pattern of a mid-cycle rebound in labor’s share is typical of past U.S. recoveries. after falling short of it since 2012. That is the Fed’s story In the three expansions during the “Great Moderation”— and they are sticking to it. I suspect, however, that at least the quarter-century after then-Fed Chair Paul Volcker broke several prominent members of the Committee would not be the back of inflation—labor’s share of income initially fell unhappy with a modest overshoot of the 2 percent inflation during the early days of recovery and then began to re- target—say 2.25 percent for a year or two—especially if it is bound during the expansion phase of the business cycle. a result of labor share rising toward its historic average. u

76 The International Economy Spring 2016