Once again, the pressing issue is labor markets and the possibility that they could ignite inflation in the U.S. economy. Increasingly, there are concerns that, despite high unemployment, the jobs market may actually be tighter than it appears. And any whiff of a rise in wages prompts almost panic-level pronouncements in bond markets that inflation will reignite.
A chart from Deutsche Bank's chief international economist, Torsten Slok, on Tuesday was headlined: "Wage Inflation Now Above Pre-Crisis Levels." It noted that median weekly wage gains at around 3 percent year over year had for the first time since the end of the recession topped the pre-crisis average. "It should be obvious to everyone by now that there is wage pressure in the pipeline and that the Fed will turn more hawkish later this year," Slok said.
Yellen appears to be trying to resist what is so obvious to Slok and others. So far, she has indicated a willingness to accept stronger wage gains. And she has not embraced a theory from Alan Krueger, the former head of the Council of Economic Advisors, a position Yellen once held, that there may be considerably less slack in the labor market than some believe.
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With Fed interest rates at zero and its balance sheet now topping $4 trillion, there is no more significant issue in economics today than whether tight labor markets will lead us into and beyond the inflationary danger zone. The worry is that the Fed has put so much fuel into the economy that any spark could ignite an inflation firestorm.
At her first press conference in March, Yellen gave her first indication of her views on the issue. "Most measures of wage increase are running at very low levels," she said.
Yellen went on to provide insight into her thinking on how high is too high for wages. "In fact, with the productivity growth we have and 2 percent inflation, one would probably expect to see, on an ongoing basis, something between—perhaps 3 and 4 percent wage inflation would be normal."
Average hourly earnings are about 2.1 percent annually, compared with 3.4 percent in the year before the recession. Factoring in inflation, wages have risen just a half point in the past year. That measure is well below the productivity gains of 1.3 percent, so workers continue not to be compensated for their growing efficiency. Put another way, wages are not rising anywhere near the level of inflation plus productivity.
Even if wage growth sparked some inflation, Yellen would have reason not to panic. In fact, the Fed wants some inflation, says economist Jared Bernstein. It's preferred inflation measure, the price index of personal consumption expenditures, is running just 0.9 percent over the year-ago level. The Fed wants 2 percent inflation. So at least a touch of wage-induced inflation would appear to be welcome by the Fed.
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But Deutsche's Slok worries about such a development. He said if the Fed stays at zero interest rates with a large balance sheet, and wages tick up to even the desired 3 percent to 4 percent level, that the Fed will be substantially behind the curve if wages or inflation rise any higher.
"For monetary policy to hold wages down, you need to be above the neutral rate," Slok said. "If you wait until wage inflation is 3.5 percent and then she says now we need to do something, it's already too late."
Jim O'Sullivan, chief U.S. economist from High Frequency Economics, argued that the still-large Fed balance sheet "will continue to provide net stimulus for years." That will further complicate Yellen's ability to rein in wage-induced inflation, should it come.
Yellen's choice is further complicated by an argument from someone who should be more ideologically sympathetic: Princeton economist Krueger. A recent paper by Krueger has become the flash point for debate over Fed policy because it relates directly to the issue of potential wage inflation.
Krueger argues that the long-term unemployed, of which there are 3.7 million, are unlikely to come back into the workforce. As a result, his argument goes, they do not exercise downward pressure on wages. His work has prompted some to take out this group when trying to gauge actual labor slack in the economy by looking at the unemployment rate.
The result: the unemployment rate for the short-term unemployed is about back to where it was before the recession. The conclusion (although this is not necessarily Krueger's) is that workers will soon have the ability to negotiate higher wage gains that could cause inflation.