• The Federal Reserve is trying to figure out how quickly to withdraw its fuel from the COVID era for the economy.
• Despite rising wages, it is clear that the Fed does not need to raise interest rates to bring inflation under control.
• This is because labor productivity follows wages, which means that inflation will not get out of hand.
• George Pearkes is the global macro strategist of Bespoke Investment Group.
• This is an opinion column. The thoughts expressed are those of the author.

How fast the

Federal Reserve
Loosen up the COVID-era fuel that has helped keep the economy moving?

While Federal Reserve officials generally agree that reducing the pace of their bond purchases this year is the right decision, how quickly they should take their foot off the accelerator, and how long afterwards they should starting to raise interest rates is still up for debate. Both camps believe their preferred path will help keep the economy rebounding longer, but their concerns are far apart.

On the one hand, wages are skyrocketing and inflation measures are on the rise, suggesting the need to raise interest rates as soon as possible. On the flip side, there are still millions of Americans unemployed with millions more remaining out of the workforce and the labor market is still recovering from the pandemic, suggesting the need to keep rates going. low interest rate to help increase employment.

But looking under the hood, there is good reason to believe that the Fed’s choice and the winner of the argument may be clearer than it first appears.

The riddle

Looking at the inflation and employment measures, it’s easy to see why the Fed thinks it is at a stalemate. The median CPI, a general indicator of consumer price inflation that focuses on typical price movements during the month, reached its highest level since the 1980s. This measure is particularly illuminating because it indicates that recent price movements have been much broader than a few pandemic-sensitive categories such as used cars or hotel prices.

At the same time, the labor market is still in turmoil: there are around 18 million people who don’t have a job when they want one, or who work part-time because they can’t find a job. no full time job.

The combination puts the Federal Reserve in a difficult position. As the chart below shows, over the past two business cycles, when the labor market was in a similar position, general price pressures were weaker. This meant that the Fed did not need to compromise between helping jobs and fighting inflation.

George pearkes

Just as the Fed has balanced the two sides of the inflation-labor market equation, there has also been the development of two teams fighting on either side. On the one hand, the “transitional team”, the pundits and academics who believe that peak inflation is always a function of pandemic disruptions, and inflation will begin to subside as supply chains settle down. . They argue that it is not necessary to hurt the job market by raising interest rates.

On the other side are the “inflationists”, who push back the ephemeral team by pointing the finger at wage increases. The problem is, when the bargaining power of labor is too high, higher wages force companies to quickly raise prices to cover ever-higher labor costs – a wage-price spiral. These fears are supported by data showing that non-management workers are seeing their wages increase at the fastest rate in nearly 40 years.

George pearkes

But a key piece of the puzzle is left out when these inflationists argue that the 1970s – an era of high inflation and high unemployment – will happen again.

Just because wages are rising doesn’t mean inflation is here to stay

Wage growth in itself is not bad; this is most appropriate when compensation is simply about keeping pace with a strong economy. But it can cause problems when it rises too quickly and starts forcing price increases elsewhere. So when do you know if the pay increases are right or wrong?

The graph below shows two series. The first is GDP per hour worked, or the value a worker can create in an hour (this measure is widely referred to as “productivity”). The other measure shows labor costs per unit of output, that is, how much it costs a firm to pay a worker to produce an actual unit of output.

Imagine a factory that uses machines, raw materials and labor to make a product. When the plant adds a more efficient machine, workers can produce more with the same number of hours worked. It is an increase in labor productivity. Now imagine the workers threatening to strike and get a raise in wages, but everything else remains the same: these are higher unit labor costs, because the wage bill is higher but output is unchanged.

The idea here is that if labor costs and productivity increase together, it is a much smaller problem than labor costs increasing on their own. In order to rise to cope, current labor costs per unit of output keep pace with increased business efficiency.

George pearkes

Let’s look at a concrete example of why rising wages don’t need to lead to a similar rise in inflation. Non-managers of restaurants and bars (average cooks, waiters and bartenders) had seen their wages increase by 22% per year until August. But the income earned by restaurants per hour worked by these employees rose from $ 60 per hour before the pandemic to $ 75 per hour. So while the cost of paying waiters and bartenders skyrockets, it doesn’t keep up with the money their employers are making.

George pearkes

Over the past two years, earnings per hour of work have increased by $ 11.15, compared to an increase in production and non-supervision wages of just $ 2.05. In other words, line workers get 18% of the extra earnings per hour, less than the 22% of the earnings per hour that their wages represented in August 2019. This is exactly the opposite of what you would expect in a large salary-price. spiral.

That’s not to say that higher wages haven’t played a role in rising prices overall, but since the start of the COVID recovery, high commodity prices, disruption in the supply chain Supply, strong consumer demand and the shift in spending from services to goods have all played more important roles than labor markets.

By raising interest rates in an attempt to calm the labor market in an attempt to reduce inflation, the Fed is not going to tackle the physical bottlenecks in production. What they will do is hurt global economic activity, the biggest blow to workers and vulnerable Americans.

As long as productivity continues to rise, strong wage growth is not automatically the harbinger of higher inflation. Unlike the 1970s, there is evidence that companies can continue to become more productive, pay people more to generate those profits, and inflation can return to a level where the Fed is more comfortable.

The Federal Reserve can still curb economic activity by raising rates, but until there is good evidence that this is the only way out, policymakers should be more cautious than inflationists do. ‘have done so far.