By Dean Baker
The decision by the Federal Reserve Board’s Open Market Committee (FOMC) to raise interest rates was unfortunate; however, its commitment to have future decisions driven by data rather than a preset timeline is encouraging. The logic in raising interest rates and slowing the pace of job creation is to prevent the labor market from becoming too tight and setting off a wage price spiral.
There is little basis for this concern at present. The core personal consumption expenditure deflator has risen at a 1.7 percent rate over the last year and shows no evidence of acceleration. Nor is there an evidence of acceleration in inflation in the pipeline, as indicated by the producer price indices and the import and export price indices.
While the average hourly wage series shows evidence of a minor acceleration of wage growth, this evidence disappears altogether in broader measures like the Employment Cost Index. The most recent data show compensation has risen by just 2.3 percent over the last year. Furthermore, this is in a context in which the labor share of corporate income is still down by more than two full percentage points from its pre-recession level. In short, there seems plenty of room to allow for the labor market to tighten and for the pace of wage growth to increase modestly, without any fears of setting off a dangerous inflationary spiral.
While the current 4.6 percent unemployment rate is relatively low, it is not clear that this is a good measure of the tightness of the labor market. Other labor market measures, such as the measures of unemployment duration and the number of involuntary part-time workers, are consistent with much higher levels of unemployment. Most importantly, the employment-to-population ratio (EPOP) for prime-age workers (ages 25-54) remains two full percentage points below pre-recession peaks and almost four percentage points below the peaks hit in 2000.
This drop in EPOPs occurred for both men and women at all levels of educational attainment. It is difficult to see an explanation for such an across the board drop in prime-age EPOPs, except the weakness of the labor market. By allowing the economy to add jobs more rapidly we will have the opportunity to test how many of the people who are now out of the labor market are actually interested in getting jobs.
On the flip side, it is difficult to see a rationale for locking in a path of rate hikes. We are clearly in a situation of poorly charted economic waters as evidence by the Fed’s consistent over-prediction of inflation in the last six years. The tighter labor market surely increases the risk of inflation, but there is no real basis for believing that we are about to see a substantial uptick in neither the inflation rate, nor, that the Fed could not still prevent inflation from becoming a problem with further rate hikes if such an uptick does occur.
In short, the policy of watchful waiting was the right path to pursue in 2016 and it will continue to be the right path to pursue in 2017, even if the new administration may adopt fiscal policies that will temporarily boost the economy’s growth.
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