Employment, wages and monetary policy The acid test

This article originally appeared in the Economist

PERHAPS the labour market has been the biggest economic puzzle in recent years. Why has productivity been so poor? Why has wage growth been so slow? (These questions are probably, but not definitely, related; workers haven't enjoyed the gains from their productivity in the past.) Why have so many people dropped out of the workforce, particularly in the US (where participation is at its lowest rate since 1978)? It looks as if we have two models; the Anglo-American one, where the economy can generate lots of poorly-paid jobs; and the continental European model, which doesn't create such jobs and maintains a two-tier system of well-paid insiders and jobless outsiders. But the nature of work itself may be changing, with fewer people tied to a specific employer and more working on a freelance basis. This can bring benefits to workers in the form of freedom of action, but at the expense of security and benefits.

All this creates a dilemma for central bankers as they try to figure out how to withdraw monetary stimulus. Their thinking is built around the concept of an output gap; while output is below trend, then inflation will not appear. Once output is above trend, prices will start to rise.

But how to measure the trend? Clearly, the economy is smaller than would have been anticipated before 2007. But by how much? Should the authorities accept the secular stagnation thesis of Larry Summers? In that case, there may be less slack than anticipated. And how should slack be measured? The Fed has suggested, then abandoned, an unemployment target; the same goes for the Bank of England. Wage growth seems to be the new variable they focus on; if the labour market gets tight, then employers will start competing for workers.

Perhaps the moment of tightness is arriving. Torsten Slok of Deutsche Bank says that the US "quit rate" - the proportion of workers who voluntarily leave their jobs - is now 2%, back at pre-crisis levels. People tend not to leave their jobs unless they feel confident they can get a better one. He adds that there has been a significant increase in the proportion of employers planning to increase wages over the next few months (annual wage growth on the latest data is still just 2%, however). In the UK, wage growth has moved above inflation for the first time in five years.

Suddenly, this has brokers talking about the potential for interest rate increases. Mr Slok says that

The bottom line is that the US economy is moving closer to full capacity and hence wage and price inflation and the Fed can easily begin to hike rates in 2015, the US economy is in much better shape than many market participants think

UBS is forecasting a Fed funds rate of 1.25% by the end of next year.

Workers will be forgiven for being a bit cynical about all this. While monetary policy was pumping up the asset markets and the richest 1% of Americans were enjoying real income gains of 31%, the other 99% had real gains of only 1%. Central banks did not find that a problem. But now that the ordinary Joe is getting a better deal, people say it is time to slam on the monetary brakes.

We will see whether the Fed does act (the Bank of England sounded very dovish this week). Central banks are understandably reluctant to raise rates because of the collateral damage that it will cause; very little of the pre-2007 debt has been paid off and a rise in rates across the curve might cause problems for business and the housing market. In addition, the recent strength of the dollar will reduce import prices and help keep the lid on inflation. And the Fed can plausibly argue that discouraged workers may re-enter the labour market, keeping the lid on wages.

But it is a difficult issue. Central banks won't want to see inflationary expectations start to rise because then they would really have to slam on the brakes. So they will want monetary tightening, like the tapering of QE, to be a gradual process. And there may never seem like a good moment to start.

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