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Having watched innumerable meetings of the U.S. Federal Reserve’s monetary policy committee, I’ve lost count of the number of times I’ve heard participants complain that uncertainties about the economy were “unusually elevated.”
But when Fed officials say this at their policy meeting this week, they’ll be unusually on point. Considering how much the Fed has already raised U.S. interest rates, this would be a good reason for the Fed to pause.
For starters, nobody seems to know where the U.S. economy is heading. More than a year of the fastest monetary tightening in decades, coupled with a tightening of bank lending standards that started even before this spring’s banking crisis, should have slowed the economy, weakened the labor market, and brought down inflation.
Instead, we’re getting mixed signals in all of these areas.
The growth of gross domestic product (GDP) slowed to about 1.2% in the first quarter, but the Atlanta Fed’s GDPNow model has U.S. growth rising to a respectable 2.2% in the second quarter. The unemployment rate rose 0.3 percentage points in May, a large increase for just one month, to 3.7%, but employment accelerated to a brisk 339,000 new jobs. The Fed’s preferred measure of price inflation, the personal consumption expenditures (PCE) deflator, has declined to 4.4% in April from a peak of 7% (on a 12-month basis) in June 2022. Yet the “core” measure, which excludes food and energy prices and is considered a more reliable measure of underlying inflation pressures, has stayed stuck at around 4.7% this year, well-above the Fed’s 2% target.
Layered on top of uncertainty about where these indicators are heading are deeper questions about the relationship between labor markets, wages and inflation in the post-pandemic economy. In the standard “Philips curve” model, overheated labor markets lead to rising wages that boost labor costs and force companies to charge higher prices. Economists, including those at the Fed, generally agree that the surge in inflation to date has not been driven by rising wages so much as by supply-chain disruptions and strong demand from earlier fiscal stimulus.
But many worry that going forward, the Philips curve relationship will reassert itself, with tight labor markets and rising wages obstructing progress toward further disinflation.
Read: The Federal Reserve is stuck in a deep hole — and it has only itself to blame
It is almost certainly the case that current rates of wage growth, running at more than 4% on a 12-month basis, would not be consistent with the Fed’s 2% inflation target in the longer run, and so would eventually need to come down.
At the same time, real (price-adjusted) wages have suffered over the past couple of years, failing to keep up with trend increases in productivity. Depending on how the gap between real wages and their trend level is resolved, there could be very different outcomes for wages, unemployment and inflation.
Controlling inflation
In a paper I recently completed with John Roberts, who used to run the macroeconomic projection model for the Fed, we analyzed different scenarios for how the wage gap might be closed. We found that if firms and their employees are both indifferent to the level of the wage gap, as standard models generally assume, future increases in unemployment and consequent declines in nominal wage growth will lead to declines in inflation but no progress in restoring real wages.
Conversely, if employees seek to make up for lost wage growth and restore their share of income while firms seek to maintain their current elevated markups of price over cost, the result is likely to be the outcome most feared by the Fed: a wage-price spiral and stagflation.
But, finally, if elevated markups put downward pressure on prices, disinflation can be achieved along with further solid wage growth that restores wages to their pre-Covid trend. This felicitous outcome would be reinforced if, as evidence suggests, recent price increases reflect to an important degree tight product markets, so that a weakening in aggregate demand leads to especially rapid reductions in corporate markups and inflation.
Unfortunately, because of the nearly unprecedented nature of the post-pandemic confluence of supply-chain disruptions, inflationary surges, real wage weakness and super-tight labor markets, it is difficult to know which of the scenarios described above will prevail.
This makes it exceedingly uncertain as to whether further monetary tightening will be needed to bring inflation under control, or whether the monetary restraint already in the pipeline will suffice to achieve the Fed’s goals. This argues for a pause in rate hikes at the Fed’s upcoming meeting and extremely watchful waiting in the months to come.
Steve Kamin is a resident scholar at the American Enterprise Institute (AEI), where he studies international macroeconomic and financial issues. He is a former head of the Federal Reserve’s Division of International Finance.
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