Not just ‘no heat’ but signs of cooling: The case for FOMC rate cuts has real merit
Federal Reserve Chair Jerome Powell’s July 10 testimony before the House Financial Services Committee was unlike any hearing featuring his predecessors.
Despite the vital importance of Fed decisions for the day-to-day lives of working families, congressional hearings featuring the Fed chair speaking about the state of the economy historically have disappointed. Disinterested and poorly informed questions posed by members of Congress have elicited opaque answers from Fed chairs.
This hearing was different. The questions were probing and informed, and Powell answered them with clarity.
Perhaps the most illuminating exchange occurred when Representative Steve Stivers (R-Ohio) asked Powell if the Fed was worried that low interest rates would cause the job market to run “hot.”
Some quick background throws Powell’s remarkable answer into sharp relief. One of the Fed’s two mandates—and the mandate that the Fed has unfortunately prioritized in recent decades—is to keep inflation under control. Traditionally, the perceived threat to controlled inflation in an expanding economy has been thought to come from the improving labor market. As unemployment falls and workers feel more confident, they can demand faster wage growth from employers. If wage growth (adjusted for inflation) exceeds economywide productivity growth, it puts upward pressure on prices (since labor costs are by far the largest component of prices).
Often in the Fed’s history, the response to Stivers’s question would have been, “Yes, unemployment this low definitely has us worried about overheating leading to inflation.” But too often this answer would have had very little empirical backing. For example, for a short spell in 2011 the estimated “natural rate” of unemployment below which inflation was forecast to begin accelerating was 2 full percentage points above today’s 3.7% rate. Yet no acceleration of inflation happened between 2011 and today.
‘To call something hot, you need to see some heat’
Powell’s answer to Stivers’s loaded question admirably reflected the facts.
We don’t have any basis or any evidence for calling this a hot labor market. We have wages moving up at 3%, which is good because it was 2% a year ago, but 3% barely covers productivity increases and inflation. And it certainly isn’t fast enough to put upward pressure on inflation. [However], we haven’t seen wages moving up as sharply as they have in the past. … 3.7% is a low unemployment rate, but to call something hot, you need to see some heat. While we hear reports of companies finding it hard to find qualified labor, we don’t see wages responding.
In this newsletter, I look for some “heat” in widely watched economic variables. But instead of seeing heat in these variables, I find pretty consistent cooling.
Wage growth has actually flattened recently
The most important indicator of a fast-warming job market is wage growth. Powell’s reference point for wage growth—the sum of productivity growth and inflation—is exactly the one EPI has used for years. Specifically, according to our Nominal Wage Tracker, as long as nominal wage growth is less than or equal to the Federal Reserve’s 2% overall price inflation target plus the growth rate of potential productivity, the labor market is not getting too “hot.” Our tracker usually looks at year-over-year changes in wages as our measure of growth. However, this measure could in theory miss (or at least obscure) quite recent accelerations or decelerations in the data.
Figure A presents our usual nominal wage growth measure for all (nonfarm) workers and a supplemental measure using a more timely (but more volatile) series measuring quarterly wage growth, and highlights a more recent period. The dark blue line in the graph measures growth relative to the same month in the previous year, and the light blue line shows wage growth measured as the average of the most recent three months relative to the average of the three preceding months. So, the last data point in this line is average wages in April, May, and June of 2019 as compared with average wages in January, February, and March of 2019. This growth is then expressed as an annualized rate to make it comparable with the other line.
Our original wage tracker shows clearly that wage growth steadily—but very slowly—improved in the years following the Great Recession. For example, growth was below 2% for much of 2010, but by December 2016 had risen to 2.7%. Moreover, as the figure shows, wage growth moved into a notably higher gear in 2018. From January 2018 to December 2018, year-over-year wage growth rose from 2.8% to 3.3%. And our more timely three-month measure of wage growth rose even faster in this period, consistent with wage growth acceleration.
One might even be tempted to call this evidence of heat. But in 2019, this growth has not just moderated but has actually decelerated slightly. In June 2019 wage growth was just 3.1%.
Clear recent deceleration in wage growth: Year-over-year change and quarterly changes in average hourly earnings
|date||12-month change||3-month change|
The data underlying the figure.
Source: EPI analysis of Bureau of Labor Statistics Current Employment Statistics public data series
The quarterly growth numbers (expressed at annualized rates) make the deceleration even clearer, as the more timely three-month measure of wage growth has dipped sharply below the year-over-year measure throughout 2019. In June 2019, this three-month measure of wage growth was just 2.7%.
As we’ve argued before, a nominal wage target really is the most important real-time indicator the Fed should be watching to assess economic overheating. If there’s no ongoing heat in this variable, the case for tightening is much, much harder to make.
Any signs of ‘heat’ in GDP, residential investment, and other variables?
Recent reports have indicated that the Fed’s intentions extend beyond just holding pat on interest rates to cutting rates in the next Federal Open Markets Committee (FOMC) meeting. Can we use the “heat check” of quarterly changes to shed any light on the wisdom of this decision by focusing on some other variables as well?
Table 1 shows growth rates for a number of variables, including average hourly earnings. It shows the annual growth rate for 2016, 2017, and 2018; the growth rate over the past six months; and the last quarter’s growth (with these last two growth rates expressed in annualized terms to make them directly comparable to the others). Essentially, this table aims to show longer-run trends in these variables as well as what has happened to them in increasingly recent periods. An “overheating” economy would see growth rates that were higher the more recently they were measured. In almost all cases we see the opposite of this pattern: Growth accelerates from 2016 to 2018, but then begins to decelerate.
Cooling extends beyond wage growth: Recent annual, six-month, and quarterly changes in key economic indicators
|Gross domestic product||Average hourly earnings||Core price deflator, personal consumption expenditures||Residential investment||Nonresidential fixed investment|
|Latest six-month change||2.6%||2.9%||1.6%||-1.3%||1.9%|
|Latest quarterly change||2.1%||2.7%||1.5%||-1.5%||-0.6%|
Sources: GDP and investment data are from the Bureau of Economic Analysis National Income and Product Accounts, Tables 1.1.3 and 2.3.4. Earnings and personal consumption data are from the Bureau of Labor Statistics Current Employment Statistics.
First, we examine growth in gross domestic product (GDP). Between 2016 and 2018 GDP growth accelerated from 1.6% to 2.9%. But in the latest six months, it decelerated to a 2.6% growth rate, and further decelerated to a 2.1% growth rate in the most recent quarter.
Next, we examine growth in the average hourly earnings measure shown in Figure A. Earnings accelerated from 2.6% to 3.0% between 2016 and 2018. But over the last six months the growth rate was 2.9%, and for the last quarter the growth rate was just 2.7%.
Growth in the price deflator for personal consumption expenditures excluding food and energy (the price inflation measure the Fed watches most closely) accelerated from 1.3% to 1.6% between 2016 and 2018. But the last six months’ growth was steady at this 1.6% rate, and growth ticked down slightly to 1.5% in the last quarter.
The next indicator we examine is residential investment—probably the component of GDP most sensitive to interest rate changes. As the Fed raised interest rates steadily (if slowly) between 2015 and 2018, this sector should be where we see evidence that these rate hikes have constrained growth. This is borne out in the data, as growth in residential investment slowed from 6.5% in 2016 to −1.5% in 2018. In the last six months residential investment decelerated a bit more slowly, contracting at a 1.3% rate. The last quarter saw a 1.5% contraction.
The second most interest-sensitive component of GDP is nonresidential fixed investment (NRFI—or business investment). NRFI accelerated from 0.7% growth in 2016 to 6.4% growth in 2018. In those years, the NRFI trends were dominated by changes in the prices of energy goods and services, with faster price growth in the energy sector inducing more business investment. But more recent data show a pronounced slowdown. In the last six months, NRFI grew at just a 1.9% rate, while it contracted 0.6% in the latest quarter.
Cooling economy does provide some basis for a rate cut
By many measures, the U.S. economy seems to be cooling. A Fed decision this week to cut rates would have some real evidentiary basis behind it.