Today we received another employment report showing that the labor market remains hot. Unemployment fell to 3.4%, a 54-year low. Employment growth was 253,000, well above trend and well above pre-report estimates.
However, by far the most important data point is the growth rate of average hourly earnings. Nominal wages rose at an annual rate of 6% in April, well above expectations. (The 12-month growth rate fell from 4.3% to 4.4%.) For a Fed trying to slow aggregate demand growth, that’s bad news. For monetary policy purposes, wage inflation is the only rate of inflation that matters.
Why does the economy remain so hot, despite more than a year of “money shortage”? Is it long and variable shifts? No. A really tight monetary policy reduces GDPN growth almost immediately. The real problem is a misidentification of the monetary policy stance.
I’ve discussed this issue many times, but people don’t seem to pay attention to it. So maybe a photo would help. In the two charts below, I give typical examples of a tight money policy and an easy money policy. Note that what really matters is the spread between the policy rate (federal funds rate) and the natural rate of interest.
It is not always true that a period of monetary shortage is associated with a drop in interest rates, but it is generally the case. Does that mean the new anglers are right – that lower interest rates represent tight monetary policy? No. For a given natural interest rate, the reduction in the key rate makes monetary policy more expansionary. This fact is evident from the way asset markets react to monetary policy surprises. But when the natural rate falls (often due to past tight monetary policy), the policy rate generally falls more slowly. To use Wall Street jargon, the Fed is “lagging the curve”.
The opposite happened in 2021-22, when the Fed raised rates more slowly than the increase in the natural interest rate. In this case, it wasn’t so much the pace of rate hikes, which was quite robust, it was that they waited too long to raise rates, when the natural interest rate had already risen sharply.
PS The natural rate cannot be measured directly; we infer its position by looking at the growth of the NGDP. That’s why I ignore interest rates and focus on the NGDP.