Yellen Poised to Rewrite Fed's Rule Book on Wages, Inflation

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Yellen Poised to Rewrite Fed's Rule Book on Wages, Inflation
Chip Somodevilla/Getty ImagesFederal Reserve Chair Janet Yellen
By Howard Schneider

WASHINGTON -- Federal Reserve Chair Janet Yellen wants to see U.S. wages climb at a much brisker clip to boost consumer spending and help workers recoup ground they lost in the last recession, but she'll have to fend off policymakers who fear that could cause inflation to surge.

As she seeks to maintain a consensus at the central bank, Yellen will have strong arguments in favor of nursing the recovery for longer and should be able to counter any calls for an early interest rate hike.

Research from the Fed's staff and her own past academic work both suggest there may be more slack in the economy than inflation hawks believe, and that businesses in recent years have been slower to raise prices than they were previously.

If that is the case, then interest rates could remain lower for longer and inflation allowed to push beyond the Fed's 2 percent target without fear of it losing control. It's a policy Yellen has indicated she is willing to pursue to encourage wage growth and bring as many workers as possible back into the full-time labor market.

The connection between faster wage gains and a healthy jobs market is emerging as a core principle for the new Fed chief, who has said she expects pay to accelerate to something close to the long-run growth rate of 3 percent to 4 percent a year from the current level of around 2 percent.

"My own expectation is that, as the labor market begins to tighten, we will see wage growth pick up some to the point where ... nominal wages are rising more rapidly than inflation, so households are getting a real increase in their take home pay," she said last week, adding: "If we were to fail to see that, frankly, I would worry about downside risk to consumer spending."

Yellen has balanced her concerns over a weak labor market and slow wage growth with a commitment to price stability in the long run. And for now, she contends, there is no tension between the two because there is so much slack in the economy.

The debate, however, may well test the limits of the Fed's tolerance for inflation. For some policymakers, that limit is already close.

In comments on Tuesday, Philadelphia Federal Reserve Bank President Charles Plosser said Fed policy had already become "too passive," and the central bank needed to better explain why another year of near zero interest rates is justified.

But it also touches on a fundamental issue: Can the United States again generate the jobs and wages growth needed to support an expanding middle class?

'Sticker Economy'

Fed staff economists accepted in 2010 that labor's share of annual U.S. output, which over a decade had dropped to around 56 percent from its long-term average of around 62 percent, was unlikely to recover.

Before that, the relative stability of labor's share of output had provided a benchmark for Fed forecasters, helping them to anticipate a rise in prices if labor's share of output crept above the norm, or a rise in wages if labor's share was below average.

But the financial crisis of 2008-2009 and the painful recovery since then has cast doubts over how wages, prices and employment will play out in the future, clouding the outlook for monetary policy and the potential date for any rate rise.

Over the last year Fed staff changed their main model for forecasting wage and price inflation to reflect evidence that companies were adjusting prices more slowly than in prior years. That implies the Fed has more time to allow wages to rise and employment to expand before having to be concerned about inflation accelerating.

Yellen's own academic work describes the potential benefits of patience as the Fed approaches its first cycle of interest rate increases in six years.

%VIRTUAL-article-sponsoredlinks%In a 1990 paper, "Waiting for Work," co-authored with her economist husband George Akerlof and another researcher, Yellen discussed how in the wake of a downturn skilled workers might wait until wages recover before returning to the labor force, rather than accept inferior pay.

One issue the Fed is closely watching is whether sidelined workers will start looking for jobs again as conditions improve. The labor force participation rate has dropped steadily, from 66.4 percent at the end of 2006 to 62.8 percent last month -- a level not seen since the late 1970s when participation rates were rising as more women joined the workforce.

Yellen also delved into an issue that has puzzled labor economists -- why wages aren't typically cut in a downturn. Her research outlined a number of possibilities, including that companies realize upsetting workers may only cost companies more in the long run as some will quit or become less productive, while rehiring in a recovery will prove more costly.

But a flip side is that, as economies recover, firms make up for the lack of wage cuts by keeping worker pay constant for as long as possible.

The San Francisco Fed, where Yellen served as president until 2010, tracks the percentage of workers whose wages did not rise in the prior year. The bank's "Wage Rigidity Meter" remains near an all-time high -- evidence it will take more time before the type of wage-growth Yellen hopes to see.

San Francisco Federal Reserve Bank President John Williams was explicit in a recent paper, saying the Fed "should trade a transitory period of excessive inflation" for stronger job markets.

Among Businesses, a Muddled Outlook

Business owners and analysts in labor-intensive industries paint a muddled picture on the ground of firms that will remain reluctant to hire unless they are jolted to a new level of certainty that the economy will expand and that the incomes of their customers will grow.

Restaurants are one of the industries that can pull less skilled and discouraged workers back into the labor force. Industry officials say there is little evidence restaurant wages, staffing levels or revenues are poised for liftoff.

Restaurant owners "want to see things shake out," and were being very careful about only hiring when they really had to, said Scott DeFife, government affairs head for the National Restaurant Association.

In the building industry, one of the sectors that continues to worry the Fed, entrepreneurs and analysts describe an economy poised for better performance -- but lodged in a circular, you-go-first stare-down among consumers, businesses and banks, with the unemployed stuck on the sidelines.

Rick Judson, owner of Charlotte, North Carolina-based Evergreen Development Group, said the first-time home buyers his business relies on will remain a reluctant lot until the economy improves. But that may not happen until people start buying more homes.

The building subcontractors he hires are similarly on the fence. They see a lack of housing supply, but are unwilling to hire carpenters and electricians in numbers large enough to address it, fearful the recovery might not have staying power.

"My subcontractors worry, do I hire four extra people, or hire two with the expectation that I ride it out for a few extra months," he said. "There is a mentality not of fear, but of caution. Extreme caution."

10 PHOTOS
9 Numbers That'll Tell You How the Economy's Really Doing
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Yellen Poised to Rewrite Fed's Rule Book on Wages, Inflation
The gross domestic product measures the level of economic activity within a country. To figure the number, the Bureau of Economic Analysis combines the total consumption of goods and services by private individuals and businesses; the total investment in capital for producing goods and services; the total amount spent and consumed by federal, state, and local government entities; and total net exports. It's important, because it serves as the primary gauge of whether the economy is growing or not. Most economists define a recession as two or more consecutive quarters of shrinking GDP.
The CPI measures current price levels for the goods and services that Americans buy. The Bureau of Labor Statistics collects price data on a basket of different items, ranging from necessities like food, clothing and housing to more discretionary expenses like eating out and entertainment. The resulting figure is then compared to those of previous months to determine the inflation rate, which is used in a variety of ways, including cost-of-living increases for Social Security and other government benefits.
The unemployment rate measures the percentage of workers within the total labor force who don't have a job, but who have looked for work in the past four weeks, and who are available to work. Those temporarily laid off from their jobs are also included as unemployed. Yet as critical as the figure is as a measure of how many people are out of work and therefore suffering financial hardship from a lack of a paycheck, one key item to note about the unemployment rate is that the number does not reflect workers who have stopped looking for work entirely. It's therefore important to look beyond the headline numbers to see whether the overall workforce is growing or shrinking.
The trade deficit measures the difference between the value of a nation's imported and exported goods. When exports exceed imports, a country runs a trade surplus. But in the U.S., imports have exceeded exports consistently for decades. The figure is important as a measure of U.S. competitiveness in the global market, as well as the nation's dependence on foreign countries.
Each month, the Bureau of Economic Analysis measures changes in the total amount of income that the U.S. population earns, as well as the total amount they spend on goods and services. But there's a reason we've combined them on one slide: In addition to being useful statistics separately for gauging Americans' earning power and spending activity, looking at those numbers in combination gives you a sense of how much people are saving for their future.
Consumers play a vital role in powering the overall economy, and so measures of how confident they are about the economy's prospects are important in predicting its future health. The Conference Board does a survey asking consumers to give their assessment of both current and future economic conditions, with questions about business and employment conditions as well as expected future family income.
The health of the housing market is closely tied to the overall direction of the broader economy. The S&P/Case-Shiller Home Price Index, named for economists Karl Case and Robert Shiller, provides a way to measure home prices, allowing comparisons not just across time but also among different markets in cities and regions of the nation. The number is important not just to home builders and home buyers, but to the millions of people with jobs related to housing and construction.
Most economic data provides a backward-looking view of what has already happened to the economy. But the Conference Board's Leading Economic Index attempts to gauge the future. To do so, the index looks at data on employment, manufacturing, home construction, consumer sentiment, and the stock and bond markets to put together a complete picture of expected economic conditions ahead.
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