BEYOND THE NUMBERS
The Fed’s dual mandate requires it to pursue two objectives in setting interest rates: full employment (a tight match between the number of job seekers and that of available jobs) and stable prices (low inflation). In doing so, the Fed has traditionally relied on estimates of the “natural rate of unemployment,” i.e., the lowest unemployment rate consistent with stable inflation.
As unemployment approaches its estimated natural rate, the Fed becomes more likely to slow the economy by raising interest rates. That’s expected to reduce the demand for labor — and thus workers’ ability to bargain for wage increases. Slower wage growth, in turn, is expected to translate into lower price inflation.
Yet estimates of the natural rate of unemployment are highly imprecise and likely too high; despite an unemployment rate approaching the Fed’s estimate, wage growth and inflationary pressures remain very low. If the Fed continues depending heavily on its unemployment-rate target and raises interest rates in the near future, it risks depriving millions of American workers of potential wage gains.
Wage targeting would help the Fed deliver on its dual mandate more effectively, Bivens explains. Compared to an unemployment-rate target, a wage-growth target would be easier to estimate. It would also relate more directly to price inflation. In fact, Bivens notes, the combination of the Fed’s inflation target of 2 percent and productivity growth of about 1.5 percent should naturally lead to a wage-growth target of at least 3.5 percent in nominal (non-inflation-adjusted) terms. Nominal wage growth has been well below this target for the past six years.
Basing decisions about interest rates on a wage-growth target is unlikely to accelerate inflation. Evidence from recent decades indicates that nominal wage growth and inflation temporarily above their targets present little economic risk.
Also, the share of income going to corporate profits instead of workers’ wages has risen in recent years. Bivens points out that even if wages exceeded the 3.5 percent target by 1 percentage point, for example, it would still take eight years for labor’s share of income to return to its pre-recession level. Rather than presenting problems, years of wage growth above the target could help counter inequality and spread the benefits of the economic recovery more broadly.
A wage-growth target should not be a “rigid rule” but rather an important complement to other data points that inform the Fed’s deliberations, Bivens argues. His proposal deserves serious consideration at the Fed.