Floor It! Fixing the Fed’s Framework With Paychecks, Not Prices

  • Summary
  • The “Problem” Of Too Little Inflation
  • An Inferior Nominal Anchor: The Quirks of Inflation and the Superiority of Gross Labor Income
  • Fixing The Fed’s Real Shortcoming: Forgone Gains in Employment And Wages
  • Ensuring Credibility When Constrained: Aligning The Framework To Popular Desires
  • The Mechanics of Our Framework: When and How To Support Gross Labor Income Growth

Summary

Much of the discussion surrounding the ongoing review of the Fed’s framework has been focused on sustainable and symmetric achievement of its 2% consumer price inflation target. The debate tends to concentrate around one main question: if the Fed can’t raise inflation to its target, will it prove less capable of lowering real interest rates in the next downturn? In our view, this obsession with consumer price inflation is misguided. For the Fed’s purposes, gross labor income (GLI), the cumulative sum of each employed person’s paycheck, is a much more robust nominal anchor than consumer prices.

The “Problem” Of Too Little Inflation

The Fed is facing an existential risk, one that goes beyond a replay of the Great Inflation, the Great Recession, or the current volatility in the Oval Office. At stake for the Fed is its relevance: is the institution that is tasked with managing business cycle risks well-positioned to cope with the next downturn?

Figure 1: “Headline Inflation” uses the deflator for personal consumption expenditures. The bias is even larger if calculated with 10-year inflation rates (1.5%). Source: University of Michigan, BEA, Author’s Calculations
Figure 2: For the last 15 years, consumers’ short-run expectations for income growth have persistently underperformed their expectations for inflation. Source: University of Michigan
Figure 3: Headline PCE is based on prices of all goods and services classified under consumer spending. Core PCE excludes food and energy items. Source: BEA

An Inferior Nominal Anchor: The Quirks of Inflation and the Superiority of Gross Labor Income

Consumer Prices Are Less Cyclical and More Idiosyncratic Than GLI

Figure 4: These correlation coefficients are based on 4-quarter changes in each of these economic indicators at a quarterly frequency. For example, the first numerical cell of this table measures the correlation between the 4-quarter change in year-over-year GDP growth and the 4-quarter change in year-over-year headline PCE inflation. 1997Q3 was chosen as the starting cutoff to the first period because that is the earliest quarter for which the ISM Non-Manufacturing PMI is available. 1994Q4 is chosen as the ending cutoff of the second period because it approximately reflects the point when long-term inflation expectations in the University of Michigan Survey begin to stabilize.
Figure 5: These correlation coefficients are based on the levels of each of these economic indicators at a quarterly frequency. For example, the first numerical cell of this table measures the correlation between the level of year-over-year GDP growth and the level of year-over-year headline PCE inflation. Sources: See Figure 4
Figure 6: Source: BEA
Figure 7: Source: BLS
Figure 8: Source: BEA
Figure 9: Source: BEA, BLS

Fixing The Fed’s Real Shortcoming: Forgone Gains In Employment And Wages

False Definitions of “Maximum Employment”

Figure 10: Source: Federal Reserve System, New York Times, Wall Street Journal
Figure 11: Source: Federal Reserve System
Figure 12: The prime-age employment-to-population ratio is a broader measure of labor market slack than the unemployment rate because it does not make strong distinctions between those who are unemployed and those who are not officially participating in the labor force. Focusing on the prime working-age cohorts (25–54 year olds) helps adjust for different labor force participation trends among certain age segments (e.g. the oldest and youngest cohorts are least likely to participate). Source: BLS
Figure 13: The strongest years for productivity growth (1992–93, 2002–03, 2009–10) have all been years where employment was declining but output growth was beginning to recover. Source: BEA
Figure 14: Source: BEA
Figure 15: Source: BEA
Figure 16: Since 2017Q4, unit labor costs growth has again corrected down while measures of individual nominal wage growth have continued to slowly accelerate. Source: BEA, BLS

Ensuring Credibility When Constrained: Aligning The Framework To Popular Desires

Central Banks Do Not Operate Within A Political Vacuum

Figure 17: Source: BEA
Figure 18: Core Inflation excludes energy, food, alcohol, and tobacco. Source: Eurostat
Figure 19: Core Inflation excludes fresh food and energy. Source: Ministry of Internal Affairs and Communications

The Mechanics of Our Framework: When and How To Support Gross Labor Income Growth

Policy Rules For Understanding The Reaction Function

Figure 20
Figure 21
Figure 22: The labor supply growth component is derived from local trends in prime-age (25–54) and non-prime-age (not 25–54) employment rates and population growth (currently 0.7%). The real wage growth component is equivalent to the 15yr annualized rate of nonfarm productivity growth (currently 1.44%). The inflation target embedded in this threshold is 2%. Keep in mind that FOMC views on the appropriate inflation target have not always been 2%.
Figure 23: “Conservative Floor” refers to the fact that the floor does not assume additional labor supply gains when estimates of labor market slack are elevated. Labor supply growth is solely a function of trends in population growth and demographic structure. Source: Federal Reserve System, BEA, BLS
Figure 24: The coefficients on GLI growth and inflation are approximated using the nominal income targeting rule in Hendrickson (2012) and a forward-looking first-difference rule in Orphanides and Williams (2008). “CF Rule” refers to the policy rule that ascribes full certainty to the Fed staff’s forecasts (yes, this is unrealistic).
Figure 25: Only when GLI growth projections broke through the floor consistent with 1% inflation did we see the Fed begin easing (September 2007).
Figure 26: The persistence of such low GLI growth projections suggested, as per the rule, that easing measures needed to be introduced earlier and more persistently until projections converged back to the GLI Floor.
Figure 27: A GLI floor that embedded a 2% inflation target would have prescribed more persistent easing. A 1% target would have prescribed modest policy tightening in the first half of 2010.
Figure 27: The CF Rule that includes a 2% inflation target would have prescribed continued policy easing throughout 2013. Whether the taper tantrum qualifies as tightening or merely the end of easing, the preference for the taper aligns more closely with a 1% inflation target under our approach.

Concluding Thoughts

The Fed’s ongoing review of its framework is a great opportunity to correct some of its persistent mistakes and recommit to the goals expressed in the Humphrey-Hawkins Act.

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Skanda is the Director of Research & Analysis at Employ America. He was previously an economist at MKP Capital Management and a research analyst at the NY Fed.

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Skanda Amarnath

Skanda Amarnath

Skanda is the Director of Research & Analysis at Employ America. He was previously an economist at MKP Capital Management and a research analyst at the NY Fed.