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Fed Debates Whether Wages or Employment Rate Will Drive Inflation

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Stubbornly high inflation is finally easing as supply chain disruptions fade and interest rates at 15-year highs put the brakes on demand. Now, Federal Reserve officials have voiced unease that prices could reaccelerate because labor markets are so tight.

At issue is what’s the right way to forecast inflation: a bottoms-up analysis of recent readings on prices and wages that puts more weight on pandemic-driven idiosyncrasies—or a traditional top-down analysis of how far the economy is operating above or below its normal capacity. 

Some inside the Fed, including its influential staff, put more weight on the latter, which would argue for tighter policy for longer. Others prefer the former, which could argue for a milder approach.

The Fed is likely to raise interest rates on Wednesday by a quarter percentage point to a range between 4.5% and 4.75%, slowing increases for the second consecutive meeting. That would give officials more time to study the effects of earlier rate rises. They are likely to debate how long to continue raising rates and how long to hold them at that higher level.

The workhorse models that Fed and private-sector economists use to predict inflation compare the country’s total demand for goods and services with their total supply as represented by the “output gap”—the difference between actual gross domestic product and potential GDP based on available capital and labor. They also lean on the Phillips curve, which predicts that wages and prices rise faster when unemployment falls below some natural, sustainable level. 

Estimating these variables is difficult even in normal times, let alone after a pandemic and amid the war in Ukraine. The natural unemployment rate can only be inferred from the behavior of prices and wages. A decade ago, Fed officials put it between 5% and 6% and then revised it lower to around 4% as actual unemployment fell below 4% without much acceleration in wages.

Their projections for interest rates and inflation in December suggest they think the natural rate has temporarily shifted up to around 4.8%, said

Aneta Markowska,

chief economist at Jefferies LLC. With unemployment now at 3.5%, that suggests the labor market is too tight and likely to keep wage pressure high.

Minutes of last month’s Fed meeting show the central bank’s staff economists think the natural rate might decline slowly because job-matching will remain inefficient, suggesting price pressures could persist for longer than previously thought. 

The staff also revised down estimates of potential output because of tepid labor force growth, leaving actual output even further above its sustainable level. Staff saw this output gap persisting until the end of 2024, a year longer than they projected just a few weeks earlier.  

“It was a significant move,” said Riccardo Trezzi, a former Fed economist who runs an economic-consulting firm in Geneva. “The staff is telling the committee, ‘You cannot give up now because if you do, we will remain significantly above 2% inflation in the medium term.’”

Still, Fed officials are wary of pinning too much on output gaps and Phillips curves. Since an overheated labor market is likely to show up first in wages, many officials see those as a better proxy of underlying inflation pressure. Wages reveal what employers think they can recover via prices or productivity and what workers expect given their own cost of living. 

SHARE YOUR THOUGHTS

Should Fed officials put more attention on the pace of declines in price and wage growth or on the output gap? Join the conversation below.

If wages continue to grow at their recent rate of 5% to 5.5% that would keep inflation well above the Fed’s 2% inflation goal, assuming productivity grows around 1% to 1.5% a year. 

This is why Fed policy makers last month revised higher their projections for inflation this year. Higher wage growth boosts aggregate incomes, providing spending power that can sustain higher prices. Officials worry tight labor markets could allow paychecks to rise in lockstep with prices, as occurred during the 1970s. 

Since last month’s meeting, there has been more evidence that labor demand may have softened, including declines in temporary hiring and hours worked. If wage growth slipped to 4%, getting inflation to 2% would be easier. 

A boost in the supply of workers would help allay wage worries. Jonathan Pingle, chief U.S. economist at UBS, believes labor shortages could ease as immigration rebounds. Last month, the Census Bureau published estimates showing net immigration for the 12 months through June topped 1 million for the first time since 2017.

Fed officials closely watch the employment-cost index because it is the most comprehensive measure of wage growth. The fourth-quarter figure is to be released Tuesday.  

Inflation as measured by the 12-month change in the price index of personal-consumption expenditures excluding food and energy fell to 4.4% last month from 5.2% in September. Though still above the Fed’s 2% goal, it moderated in the last three months to an annualized 2.9%. 

Inflation is slowing because prices of goods are falling. Large increases in housing costs have slowed but haven’t filtered through to official price gauges yet. As a result, Fed Chair

Jerome Powell

and several colleagues shifted attention recently toward a narrower subset of labor-intensive services by excluding prices for food, energy, shelter and goods. 

Mr. Powell has said prices in this category, which rose 4% in December from a year earlier, offer the best gauge of higher wage costs passing through to consumer prices.

In a speech this month, Fed Vice Chair

Lael Brainard

offered a more optimistic reassessment of that view, highlighting reasons the links between wages and prices for non-housing service prices might be weaker.

She pointed to the prospect for price increases to moderate if they reflect the ripple effects of recent global dislocations that are now reversing—as opposed to the growth in wages. Prices of restaurant meals, car insurance and airfares, for example, could ease if they have been primarily caused by the pass-through of higher food prices, car prices, and fuel prices, respectively. 

“If wage pressures are moderating on their own, it becomes harder to tell a story where you’re going to be really worried about a wage-price spiral developing,” said Mr. Pingle of UBS. 

John Roberts, a former Fed economist, said he sees some scope for declining non-wage costs to ease pressure on services inflation. “But in the medium term, I have to lean on Powell’s argument here,” he said. “If wage growth stays as high as it has been, they will still have an inflation problem.”

Write to Nick Timiraos at [email protected]

Copyright ©2022 Dow Jones & Company, Inc. All Rights Reserved. 87990cbe856818d5eddac44c7b1cdeb8



Stubbornly high inflation is finally easing as supply chain disruptions fade and interest rates at 15-year highs put the brakes on demand. Now, Federal Reserve officials have voiced unease that prices could reaccelerate because labor markets are so tight.

At issue is what’s the right way to forecast inflation: a bottoms-up analysis of recent readings on prices and wages that puts more weight on pandemic-driven idiosyncrasies—or a traditional top-down analysis of how far the economy is operating above or below its normal capacity. 

Some inside the Fed, including its influential staff, put more weight on the latter, which would argue for tighter policy for longer. Others prefer the former, which could argue for a milder approach.

The Fed is likely to raise interest rates on Wednesday by a quarter percentage point to a range between 4.5% and 4.75%, slowing increases for the second consecutive meeting. That would give officials more time to study the effects of earlier rate rises. They are likely to debate how long to continue raising rates and how long to hold them at that higher level.

The workhorse models that Fed and private-sector economists use to predict inflation compare the country’s total demand for goods and services with their total supply as represented by the “output gap”—the difference between actual gross domestic product and potential GDP based on available capital and labor. They also lean on the Phillips curve, which predicts that wages and prices rise faster when unemployment falls below some natural, sustainable level. 

Estimating these variables is difficult even in normal times, let alone after a pandemic and amid the war in Ukraine. The natural unemployment rate can only be inferred from the behavior of prices and wages. A decade ago, Fed officials put it between 5% and 6% and then revised it lower to around 4% as actual unemployment fell below 4% without much acceleration in wages.

Their projections for interest rates and inflation in December suggest they think the natural rate has temporarily shifted up to around 4.8%, said

Aneta Markowska,

chief economist at Jefferies LLC. With unemployment now at 3.5%, that suggests the labor market is too tight and likely to keep wage pressure high.

Minutes of last month’s Fed meeting show the central bank’s staff economists think the natural rate might decline slowly because job-matching will remain inefficient, suggesting price pressures could persist for longer than previously thought. 

The staff also revised down estimates of potential output because of tepid labor force growth, leaving actual output even further above its sustainable level. Staff saw this output gap persisting until the end of 2024, a year longer than they projected just a few weeks earlier.  

“It was a significant move,” said Riccardo Trezzi, a former Fed economist who runs an economic-consulting firm in Geneva. “The staff is telling the committee, ‘You cannot give up now because if you do, we will remain significantly above 2% inflation in the medium term.’”

Still, Fed officials are wary of pinning too much on output gaps and Phillips curves. Since an overheated labor market is likely to show up first in wages, many officials see those as a better proxy of underlying inflation pressure. Wages reveal what employers think they can recover via prices or productivity and what workers expect given their own cost of living. 

SHARE YOUR THOUGHTS

Should Fed officials put more attention on the pace of declines in price and wage growth or on the output gap? Join the conversation below.

If wages continue to grow at their recent rate of 5% to 5.5% that would keep inflation well above the Fed’s 2% inflation goal, assuming productivity grows around 1% to 1.5% a year. 

This is why Fed policy makers last month revised higher their projections for inflation this year. Higher wage growth boosts aggregate incomes, providing spending power that can sustain higher prices. Officials worry tight labor markets could allow paychecks to rise in lockstep with prices, as occurred during the 1970s. 

Since last month’s meeting, there has been more evidence that labor demand may have softened, including declines in temporary hiring and hours worked. If wage growth slipped to 4%, getting inflation to 2% would be easier. 

A boost in the supply of workers would help allay wage worries. Jonathan Pingle, chief U.S. economist at UBS, believes labor shortages could ease as immigration rebounds. Last month, the Census Bureau published estimates showing net immigration for the 12 months through June topped 1 million for the first time since 2017.

Fed officials closely watch the employment-cost index because it is the most comprehensive measure of wage growth. The fourth-quarter figure is to be released Tuesday.  

Inflation as measured by the 12-month change in the price index of personal-consumption expenditures excluding food and energy fell to 4.4% last month from 5.2% in September. Though still above the Fed’s 2% goal, it moderated in the last three months to an annualized 2.9%. 

Inflation is slowing because prices of goods are falling. Large increases in housing costs have slowed but haven’t filtered through to official price gauges yet. As a result, Fed Chair

Jerome Powell

and several colleagues shifted attention recently toward a narrower subset of labor-intensive services by excluding prices for food, energy, shelter and goods. 

Mr. Powell has said prices in this category, which rose 4% in December from a year earlier, offer the best gauge of higher wage costs passing through to consumer prices.

In a speech this month, Fed Vice Chair

Lael Brainard

offered a more optimistic reassessment of that view, highlighting reasons the links between wages and prices for non-housing service prices might be weaker.

She pointed to the prospect for price increases to moderate if they reflect the ripple effects of recent global dislocations that are now reversing—as opposed to the growth in wages. Prices of restaurant meals, car insurance and airfares, for example, could ease if they have been primarily caused by the pass-through of higher food prices, car prices, and fuel prices, respectively. 

“If wage pressures are moderating on their own, it becomes harder to tell a story where you’re going to be really worried about a wage-price spiral developing,” said Mr. Pingle of UBS. 

John Roberts, a former Fed economist, said he sees some scope for declining non-wage costs to ease pressure on services inflation. “But in the medium term, I have to lean on Powell’s argument here,” he said. “If wage growth stays as high as it has been, they will still have an inflation problem.”

Write to Nick Timiraos at [email protected]

Copyright ©2022 Dow Jones & Company, Inc. All Rights Reserved. 87990cbe856818d5eddac44c7b1cdeb8

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