Don’t wait on wage growth—the Fed should cut rates at this week’s meeting

Over the past six months, core inflation has risen exactly in line with the Federal Reserve’s long-run 2% inflation target. When this key measure of inflation (which excludes volatile food and energy prices) is neither above nor below this target, this is a good sign that the Fed’s policy should be roughly neutral—aiming to neither increase nor depress economic activity.

Yet Fed interest rate policy today is nowhere near neutral—instead it is putting a stiff drag on potential growth. The Fed’s main policy instrument—the federal funds rate—stands between 5.25 and 5.5%, its highest level since at least the business cycle peak of 2007 (and maybe even the peak of 2000). There are a lot of debates among economists about the correct “neutral” level of interest rates in the economy (and even debates about whether it exists or is a useful guide to policy at all), but nobody thinks today’s rates are even close to neutral. Instead, interest rates closer to 2.5-3% are likely needed to keep monetary policy from continuing to threaten growth. (Rates lower than this would likely start providing some stimulus to the economy, which does not seem needed at the moment.)

Given that inflation has been brought all the way back down to the Fed’s target, further economic cooling is no longer needed, and the Fed should move quickly to a more neutral stance.

The Fed’s own summary of projections predicts that the federal funds rate will be a full percentage point lower by the end of 2024. Some private sector forecasters have predicted more aggressive rate cutting. Nearly all these forecasts assume these cuts could begin at the Fed’s March meeting, not this week. But if we’re already at the inflation target, why wait to cut? Every month with interest rates at elevated levels that cool growth is a month where the Fed flirts with overdoing their fight against inflation and dealing a bad blow to the economic expansion. When inflation was running above the Fed’s target, there was some rationale for this (not very good ones, but some), but this rationale is now gone, and the Fed should act appropriately.

Some have argued that today’s pace of wage growth is too fast to be consistent with the Fed’s price inflation target over the long run, hence the Fed needs to wait until there is further cooling of wage growth before cutting rates. This is a bad diagnosis. Today’s pace of wage growth is perfectly appropriate given the economic context, and the Fed shouldn’t wait for wage growth to return to pre-pandemic levels before pulling rates back down.

Given the Fed’s 2% inflation target, wages can rise by 2% plus the rate of productivity growth without putting any upward pressure on inflation. Productivity growth is a measure of how much workers produce in an hour of work. If it rises by 1%, this means every hour of work is generating 1% more output, and hence the price of this output can fall by 1% even with wages constant. The pace of productivity growth is hard to confidently assess in real-time, but if one assumes a long-run average of 1.5% will hold going forward, then wage growth can be 3.5% annually while putting no upward pressure on a 2% inflation target. In the last quarter of 2023, average hourly earnings for all workers rose at a 3.7% rate.

Besides being already awfully close to an appropriate long-run wage target, the 3.7% growth rate in the fourth quarter is almost a full percentage point slower than the pace of wage growth a year ago. Wage growth is not some rigid outlier that is not adjusting even as the rest of the economy does—it is moving quickly back to the pre-pandemic normal along with prices.

Further, to the degree that we do have some real-time data on productivity growth, it has shown a remarkable surge in the past year. In the third quarter of 2022, measured productivity had shrunk by 1.7% over the previous year. In the third quarter of 2023, it had risen by 2.3% over the past year. This is an enormous positive swing—and preliminary data indicate strongly that productivity growth was also very strong in the last quarter of 2023. This means that even while productivity growth was creating a lot more “room” for wage growth over the past year, wage growth decelerated. This further means that pressure on prices coming from labor market costs (the combined effects of wage growth and productivity growth) has relented a lot in the past year—and that pressure never really was a big deal in the first place, as most price inflation came from influences outside the labor market.

Finally, it is worth noting that the labor share of income in the corporate sector remains significantly lower than it was pre-pandemic (when it is measured properly). Figure A below shows that the labor share dropped from 75.5% in the fourth quarter of 2019 to 73.7% today. There is every reason to think that this lost labor share can (and should) eventually claw back if strong labor markets are allowed to continue in a context of normalizing inflation. This also means that firms still have abnormally high profit margins today. If these margins move closer back to their 2019 levels, this could allow continued wage growth without inflationary pressures.

The “shock absorbers” of accelerating productivity growth and a potential rise in the labor share of income should provide the Fed more than enough comfort to start cutting interest rates, even with wage growth running a bit faster than it did pre-pandemic. The job is essentially done on price inflation, and the risks of damaging the expansion rise every month that interest rates remain high. There is no need to wait on wage growth to fully normalize before the Fed starts reducing these recession risks.

Figure A

Still room for profits to fall and make room for wage growth: Labor share of income in the corporate sector, 2000–2023

date Labor share
Jan-2000 81.8%
Apr-2000 82.0%
Jul-2000 82.5%
Oct-2000 83.2%
Jan-2001 83.2%
Apr-2001 82.9%
Jul-2001 83.1%
Oct-2001 84.1%
Jan-2002 82.3%
Apr-2002 82.0%
Jul-2002 81.8%
Oct-2002 80.8%
Jan-2003 80.3%
Apr-2003 80.2%
Jul-2003 79.8%
Oct-2003 79.9%
Jan-2004 78.7%
Apr-2004 78.6%
Jul-2004 78.5%
Oct-2004 78.4%
Jan-2005 77.1%
Apr-2005 76.8%
Jul-2005 76.9%
Oct-2005 75.7%
Jan-2006 75.3%
Apr-2006 75.2%
Jul-2006 74.6%
Oct-2006 75.9%
Jan-2007 77.2%
Apr-2007 76.7%
Jul-2007 78.0%
Oct-2007 79.0%
Jan-2008 79.5%
Apr-2008 79.5%
Jul-2008 79.8%
Oct-2008 83.6%
Jan-2009 79.8%
Apr-2009 79.4%
Jul-2009 78.4%
Oct-2009 77.4%
Jan-2010 76.3%
Apr-2010 76.8%
Jul-2010 74.8%
Oct-2010 74.9%
Jan-2011 77.1%
Apr-2011 75.9%
Jul-2011 76.0%
Oct-2011 74.2%
Jan-2012 73.9%
Apr-2012 74.1%
Jul-2012 74.4%
Oct-2012 75.1%
Jan-2013 74.7%
Apr-2013 75.0%
Jul-2013 75.1%
Oct-2013 74.8%
Jan-2014 76.0%
Apr-2014 74.1%
Jul-2014 73.3%
Oct-2014 73.7%
Jan-2015 74.2%
Apr-2015 74.3%
Jul-2015 74.9%
Oct-2015 75.3%
Jan-2016 74.9%
Apr-2016 75.4%
Jul-2016 75.4%
Oct-2016 75.6%
Jan-2017 75.9%
Apr-2017 75.9%
Jul-2017 76.3%
Oct-2017 76.1%
Jan-2018 75.8%
Apr-2018 75.3%
Jul-2018 75.2%
Oct-2018 75.4%
Jan-2019 76.0%
Apr-2019 76.1%
Jul-2019 75.4%
Oct-2019 75.5%
Jan-2020 77.8%
Apr-2020 77.5%
Jul-2020 73.2%
Oct-2020 75.6%
Jan-2021 74.1%
Apr-2021 72.7%
Jul-2021 73.6%
Oct-2021 74.1%
Jan-2022 74.2%
Apr-2022 73.0%
Jul-2022 73.0%
Oct-2022 72.9%
Jan-2023 73.6%
Apr-2023 73.9%
Jul-2023 73.7%
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Note: Data from the National Income and Product Accounts (NIPA) Tables 1.14 and 6.16. Profits of Federal Reserve Banks are stripped out. Precise measure is labor compensation divided by the sum of labor compensation and net operating surplus. 

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