The Federal Reserve and Stagnating Wages

I've written before about stagnating household wages in the US. My sense is that while wages have stagnated in recent decades, the growth living standards have not, and issues in the provision of government goods, education, and healthcare have a lot to do with why growth in income isn't keeping up with growth in real consumption spending.

Mike Konczal has proposed one different explanation centered on the recent behavior of the Federal Reserve:

Here’s a question I’ve been trying to find research on lately – how much is the post-Volcker era of monetary policy responsible for stagnating wages and high-end inequality? I’m pretty familiar with the stories and arguments surrounding these two topics, and the Federal Reserve never shows up. It’s almost like taking an American phone charger overseas; there’s no place for monetary policy to “plug-in” the current research and arguments, from technology to superstars to policy to everything else, on wages/inequality.  Which is weird, since when you read transcripts of their FOMC meetings, released years after the time when they were recorded, the board members are obsessed with wages.   We have a sense of the Greenspan Put for the financial sector, but what’s the Greenspan option-metaphor for workers?

I was pretty skeptical of this idea when I first heard this. By what mechanism does the Fed targeting wage growth instead of CPI growth actually manifest itself into stagnating wages? Still, I wasn't able to think of a more effective argument against this on the spot. Nick Rowe, in a recent set of posts on related issues, argues against this idea much better:

1. Consider this policy proposal:
"I think the Bank of Canada should switch from targeting CPI inflation to targeting wage inflation. I'm not hung up on the exact rate of wage inflation the Bank should target. My guess is that something like 2.5% wage inflation would be roughly right, and would give us roughly the same 2% CPI inflation in future. But if you want to argue for a higher or lower target rate of wage inflation, I don't really care a lot. So if wages start to increase faster/slower than 2.5%, the Bank of Canada should raise/lower interest rates, reducing/increasing demand for goods and labour, which would put downward/upward pressure on wage increases."
(BTW, I'm not actually proposing that, though it's not a bad policy, and is worth considering. And the merits or demerits of that proposal is not the point of this post.)
2. Reactions.
2a Macroeconomists. Any New Keynesian (for example) macroeconomist would react to the above policy proposal like this:
"Ho hum. Nothing new here. Nick hasn't even given us any reasons why targeting wage inflation would be better than targeting CPI inflation. I could build a model where one would be better in some cases, and the other would be better in other cases. It all depends on: whether wages are stickier than prices; on the source of the shocks; the exact specification of the model and its parameter values; and stuff like that. It might matter in the short run, but won't matter much if at all in the long run (unless better performance in the face of short run shocks leads to a higher growth rate).

The post goes on to discuss various other issues. But I think this snippet here captures the gist of the critique. Even if the Fed were somehow actually targeting wage inflation; there is a whole set of models out there that imply that the impact on actual real wages is a lot more indeterminate than you might think.

Of course, one could probably develop a model in which wage stagnation was the logical outcome of targeting nominal wages; or one could reject the New Keynesian paradigm entirely (in which case one should probably stop reading Paul Krugman as well). It was just nice for me to run into some critique (however ill-defined) against the idea that stagnating wages are due to the Fed's policy target.

The Rentier Class and Monetary Policy

Reihan Salam flags this bit from J.P. Morgan report on why there has been so much resistance to the Fed’s actions:

To understand why, consider Mr and Mrs James Rentier (a), an apocryphal family in their early 50’s living in upstate New York. The Rentiers are middle income: $80,000 in adjusted gross income, 3 children and $300,000 in savings after setting aside 10% of their income over the last 30 years. Over time, as they aged and given their limited safety net, they shifted their investments into cash and short term fixed income. The current tax system is friendly to the Rentiers; at their income level, after standard deductions, available child tax credits and the payroll tax holiday, their fully-loaded effective tax rate is around 14.5%. But now consider the impact of QE (quantitative easing) on this family. Money market yields, in a normal cycle, are ~ 2% over core inflation; that would be around 3.5% today Zerophilia deprives this family of ~$8,200 per year in after-tax interest income. How substantial is that? Let’s normalize interest rates, and then compute the increase in effective tax rates that results in the same amount of after-tax income the Rentiers have today. As shown below, the punitive impact of QE on this family is the same as raising effective tax rates by one third. These are the unintended consequences of QE: a wealth transfer froms avers to the over-leveraged, and perhaps, to owners of stocks, although this latter channel isn’t working that well. Note: this is before considering the impact of rising commodity prices on the Rentiers (the Fed rejects the notion that QE affects commodities).

The implication here is that all monetary policy doe is lower interest rates, serving as an implicit tax on the holders of capital. One hears a lot of this talk, and it’s worth wondering why there seems to be so much political backlash against federal reserve easing actions.

The key here though is that this analysis narrowly focuses on the short-term impacts of easing against the broader impacts. In the short term, more easing (say, in the form of further quantitative easing) may well lower long-run interest rates (the liquidity effect). But in the long run, easing serves to increase total nominal spending, and so expectations of future inflation. This is the Fischer effect, and it works to raise long-run interest rates.

A lot of people seem to be upset right now that interest rates are low; but that’s not

solely a function of the Fed. The “natural” Wicksellian rate of interest is low due to a weak economy. Successfully targeting a future path of nominal spending higher than that expected today would lead to a robust economic recovery and higher inflation expectations — and so actually higher interest rates in the future. That’s why Milton Friedman identified low interest rates with tight, rather than loose, money.

So phrasing this issue as a “economic recovery on one hand, low rates on the other” dilemma is short-sighted. The path to both economic recovery and higher rates lies in more easing. And if you look internationally, the countries that have done the most to implement expansionary monetary policy have the higher interest rates. In Sweden, Lars Svensson has pioneered a variety of unorthodox monetary policy tools — including setting a negative interest rate on reserves, and robust quantitative easing. The result has been an economy that has recovered to a pre-crisis trend rate of growth:

That has provide the Swedish Central Bank with sufficient leeway to see rising interest rates, led by Central Bank rate hikes. By contrast, Japan has been far more reluctant to embrace an expansionary monetary policy in terms of raising its price level; and so has seen low interest rates for decades. It’s hard to think that Japan is a better place for rentiers than Sweden.

There’s been substantial discussion of how it is that people in the economy somehow don’t perceive this. Brad DeLong has argued that the Great Depression era rentier class was opposed to inflation as their profits were entirely insulated from the suffering of common folk. By his argument, people are sufficiently

It’s hard to know what to think about this. The rentier class in the Great Depression was also devastated by overall economic losses. A reluctance to embrace expansionary monetary policy in an environment of a persistent demand shortfall and very low inflation doesn’t seem to make too much private economic sense. One imagines that the rentier class is simply mistaken

Why the Focus on Government Spending?

Once, economists believed that fiscal stimulus was basically worthless, and monetary policy determined cyclical variations. For instance, here is Paul Krugman in 1997:

Indeed, if you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: It will be what Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God

Though I can't find it; I've seen a policy bit from Larry Summers dating from the '80s or so that was extremely dismissive of the possibility of any fiscal stimulus. This sort of general impulse had knock on effects on all sorts of other policy debates. For instance, future Obama Administration official Jason Furman argued in favor of Wal-Mart in a Slate debate, in which one of his points was:

I believe that Ben Bernanke and the Federal Reserve decide the total number of jobs nationwide.

The general idea was that -- let's hand off the task of aggregate demand management to the Fed, and then otherwise pursue as many pro-growth strategies as possible. Who cares if Wal-Mart costs a few jobs somewhere? The Fed will create them elsewhere. Who cares if free trade results in the loss of a few jobs in Ohio? We'll make enough money from positive-sum trade interactions to make the deal worthwhile, and possibly redistribute back to those newly unemployed. With a strong economy, hopefully they can be retrained and find new jobs.

One of the things that we've seen in the last few years is that this belief has broken down entirely. No one seems to believe that the Fed bears the brunt of the work in generating jobs; or that fiscal stimulus is a typically unworkable solution to economic woes. Instead, we've come to see the economy overall as "Y = C + I + G + X" and think "If government spending goes down even a little bit, the economy will grow unacceptably slowly." More generally, the sorts of positive-sum economic interactions we loved in the past are less popular, because any negative side effects they generate are seen as imposing unacceptable burdens on struggling folks.

And so you have various people complaining about what this debt deal or what future cuts will have on jobs. This is just a type of debate we never really had before now; in the early 2000s for instance, you had the Republicans proposing a "Keynesian" strategy of lower taxes, while Democrats opposed that. But the aggregate demand management aspect of those cuts was less important than their inherent value as tax cuts.

Opinions on the composition of government spending or taxes differ. We should, in theory, be able to have perfectly reasonable discussions about how much we ought to spend or tax without worrying inordinately about how those discussions affect the labor market. If a central bank is properly targeting inflation or the price level, it will lean against government spending in either direction, meaning that no level of government spending has any effect on the economy in aggregate. That way, we can spend all of our time arguing whether or not any particular spending or tax bill makes sense on its own merits. People back in the '90s and '80s had the right idea.

We've sort of stopping doing that. A strong goal on the left seems to be ensuring that government spending remains as high as possible; because otherwise that will ensure doom to a poorly functioning recovery. On the right, the goal too is to keep taxes as low as possible, because households too are struggling. Perfectly reasonable policy debates have become infected with the idea that the balance of public spending and taxation is the primary determinant of broader economic outcomes. So you can't argue in favor of any sort of spending cuts without being some kind of economic arsonist.

I suppose one critique of this is that given such a large output gap and a Fed unwilling to adopt price-level targeting, an inordinate focus on the total amount of government spending makes sense. My response is that it must surely be easier to have the Fed do now what it did during the '90s, so Krugman can again write about how the unemployment rate is set by the Fed, so politicians can spend and tax as they please.

There's the other critique I guess that monetary policy can't perform the same function now due to the zero rate bound, or weak banks, or struggling households. All I can say is: there is an enormous literature on monetary policy, and exactly none of it focuses on the barriers to monetary policy, as least as far as I know. None of it says, "monetary policy works if X, Y, and Z happen." Monetary policy just works, at least in theory.

In practice, we saw monetary policy drive the recovery in 1933 when FDR took the US off of the gold standard, in an environment in which we also were at a zero rate bound; faced weak banks; and financially indebted households. The initial reaction of the economy to the first round of quantitative easing under exactly these conditions was positive; as was the reaction in the second round. The only real counterpoint seems to be the case of Japan. Yet as Scott Sumner has mentioned repeatedly; the Japanese Central Bank really seems to behave as if it does like a zero percent rate of inflation, and QE has helped them maintain that.

But fine, suppose you say I'm crazy for focusing on monetary policy so much. What about other broader labor market policies? Garett Jones links to a paper on the German labor force experience, which basically finds that their flexible labor markets did a great deal to limit the employment impact of the Great Recession. Why isn't there a greater focus on generating specific policies to target unemployment, rather than worrying every time the government spends a penny less?

Energy Prices

Matt Rognile is blogging again, and has a post up on how the federal government ought to provide some sort of insurance against the cost of rising gas prices.

I’m sympathetic to this sort of thinking. I think it’s clear that a large part of what motivates hard money advocates is the fact that constant energy fluctuations leave an immediate impact on the purchasing power of families. Raj Chetty, someone who I seem to cite all of the time, has emphasized the role of commitment goods (like mortgage or auto payments) in reducing the discretionary income available for families. Fluctuations in the price of an essential good can hurt families tremendously, even if the actual price or consumption impact is small in relative terms, especially if families are credit constrained.

Meanwhile, to the extent that energy fluctuations signal permanently higher prices, they also induce structural changes in the household demand for items like energy saving cars. Yet, again due to credit constraints, households may be unable to adjust their assets — while the higher immediate cost of making gas payments may actually make it harder for them to change cars.
A recent paper by Nick Souleles and co-authors have some evidence suggesting that the Bush economic stimulus payments in 2008 ended up performing exactly this insurance role. Aside from delivering payments around the worst time of the oil shock — these payments (roughly $300-1200 ) also relieved a collateral constraint for many families. Their evidence suggests that many families used the money as down payments for more gas-efficient cars. Jonathan Levin's research (in part, what has won him a John BatesClark Medal) suggests that amounts of this size can indeed serve as down payments for subprime auto loans.

On top of the household benefits of hedging against an unexpected rise in prices for constrained households, there are the larger effects of oil shocks. Increasing durable consumption right at this time may have helped auto companies avoid even worse losses. Also, there's the issue that gas prices make macroeconomic stabilization much more difficult. A large part of this last recession was attributable to high gas prices, while a persistent oil deficit worsens the current account deficit. In classical theory, that isn’t so worrisome by itself, as a current account deficit will eventually be balanced out by higher future exports or capital inflows.

But high capital inflows can be very dangerous. In general, they tend to be associated with asset price appreciation, and a skew in domestic prices away from (increasingly uncompetitive) tradable goods and towards durable, non-tradable goods (like housing and real estate). This has been a contributing factor behind the Asian crisis, and may have been a large factor behind the most recent crisis.

However, despite bemoaning this state of affairs, the Fed has decided to do very little about this. Bernanke’s research has pointed to the need to respond to an energy shock by loosening policy; yet the dictates of an inflationary target would demand a contractionary response just as the economy is reeling from the effects of higher oil prices. His paper in fact found that energy shocks are contractionary exactly in part due to a misguided monetary shock. This debate is basically going on now, as higher oil prices driven by global factors are hurting the economy; yet are used by hard money advocates as evidence that easing has gone too far.

Bernanke has also complained about the impact of a global “supply glut” that led to large capital inflows, and fueled the demand for structural financial products that could offer seemingly high rates of return at low cost. Yet he hasn’t taken the next step of thinking through (publicly) how the US should respond. Some set of measures imposing capital controls or active management of foreign reserves to target international currency rates would affect net financial flows. Yet these ideas, while implemented routinely in the world’s central banks, remain verbotten at the Fed. This sort of stuff is the job of the Treasury, which has no tools to implement any of these targets, and in any case is mostly interested in obtaining as low interest rates for federal debt as possible.

However, even without trying out capital controls, simply lowering the level of imports of oil would have an enormous effect on current accounts deficit, and so on the degree of net capital inflows that result. As Calculated Risk always points out, America would be much closer to trade balance excluding the impact of oil.

America's dependence on oil is bad. It's bad for households and it's bad for the economy. It's not crazy to think about ways to move away from oil, both to avoid the impact of transitory shocks, as well as the costs of long-term dependance.