What’s at Stake If the Fed Prematurely Raises Rates

The following is a slightly edited version of remarks delivered on an Economic Policy Institute teleconference on Friday, July 25, 2014. 

Any systematic look at the current data on the U.S. labor market says that the large costs of the incomplete recovery are quite apparent. We still have a labor market that faces three major ongoing problems. The first is that our very incomplete macroeconomic recovery means that we have continuing high cyclical non-employment and a lot of slack left in the labor market. Even if you look at prime-age workers, those 25 to 54 years old, we’re only one-third of the way back in terms of the employment rate to where we were before the Great Recession.

If you look at young workers, the situation is particularly dire. We still have close to record low employment rates for those less than 25 years old. For disadvantaged and minority young men, the fraction that are both out of school and out of work has increased enormously since 2007; for young black males aged 20 to 24 by almost 10 percentage points from about 23 percent to 32 percent. Over the last year, we are finally seeing some significant recovery in employment, but it’s not nearly enough yet to make people whole and create real opportunities for those in many low-income and working-class communities.

Second, even as we get back closer to full employment, from which we remain very far from, we will still have the scars of the Great Recession including huge increases in the long-term unemployed and in disconnected young workers who have not gotten the types of opportunities needed to jump start their careers and to be poised to move up the career ladder in a stronger economy. So we will need to run a tight labor market for longer than normal—possibly even allowing inflation to eventually overshoot the Fed’s target for a modest period as suggested in a recent paper by Glenn Rudebusch and San Francisco Fed President John Williams—just to help make many American families whole once again and to make enough progress in combating long-term unemployment.

And third, even if we had never had the Great Recession and had the sort of the labor market that prevailed 2007, we should remember that we were in a period of stagnant real wages for most Americans, rising inequality, and poor employment opportunities for young graduates in many areas.

And to reinforce this point, if the Fed, which is the only game in town, in terms of trying to help get a stronger recovery, started putting on the brakes now, what we could end up seeing is devastation for three important groups: middle class families, the long-term unemployed, and young and disadvantaged workers. The typical American worker is not seeing any real wage growth yet. Nominal wages themselves have barely been increasing over the last year. The median worker has seen almost no wage increase at all, while inflation is running 1 to 2 percent, which is under the Fed’s target for inflation. This means real wages have been falling. Almost every index we have of compensation and wages shows very little nominal wage growth over the last year or so. So the typical family is seeing stagnant or declining earnings, even for those that are continually employed.

The labor market is weak enough that the long-term unemployed and displaced workers see devastating earnings losses, 50 percent or more, and have very little chance of getting reconnected to employment. We continue to have more long-term unemployed than at any time from the Great Depression in the 1930s to the Great Recession. While the situation has improved a bit over the last year, long-term joblessness remains extraordinarily high, and we have too many people who became disconnected from the labor market, who will need a tight labor market to bring back.

And third, young workers face a difficult and unforgiving labor market. Even many young college graduates have seen declining earnings and poor employment prospects in the 2000s.

In terms of the Federal Open Market Committee, what you see is that core inflation is not taking off. In fact, the latest CPI numbers showed only 0.1 percent increase in core inflation in the last month. Over the last year, there are no signs of big inflation increases. In terms of wages and the labor market, a reasonable approach for the Fed, rather than just looking at the unemployment rate in isolation, which has problems as a labor market indicator because of all the people who have dropped out of the work force in recent years—one ought to be looking at whether wages are rising by enough to provide sustainable, real wage increases for American families.

Basically, in a normal, well-functioning economy, real wages should grow in line with productivity increases. So that means with a 2 percent Fed inflation target that wages should grow on average at about 2 percent faster than average or trend productivity growth. Under such a scenario, average real wages grow with productivity and there is no labor market pressure towards accelerating inflation. Most experts think trend productivity growth is probably 1, to 1.5 percent a year, so we ought to be seeing nominal wages rising at least 3 to 3.5 percent a year to be in a normal sort of economy to be consistent with the Fed’s price inflation target of 2 percent a year. As the numbers show, we are typically seeing nominal wage growth, in the most recent numbers, less than 1 percent a year, and even over the last few years, clearly less than 2 percent a year.

So we continue to have tremendous slack in the labor market, a very incomplete recovery, and we need the Federal Reserve to continue its policies of maintaining accommodation and low interest rates, to give us any chance of trying to get to a more normal economy, and continuing the progress we’ve seen over the last year, where we’re actually seeing employment rising enough to raise the employment-population ratio without setting off inflation. I see no evidence-based case for saying there currently is any significant labor market pressure pushing up wages that could lead to inflation accelerating and getting out of hand. In fact, the labor market continues to be weak, but the Fed’s policies have been succeeding in getting some improvements, and given the complete lack of help from fiscal policy, the Fed remains the only responsible macroeconomic policy actor and essentially the only game in town.

If fact, we still need more expansionary fiscal policy and the time is now for greater infrastructure spending with low interest rates and a lot of unemployed workers (many from the still-depressed construction sector). We ought to be providing more assistance to long-term unemployed, including restoring some manner of extended Unemployment Insurance benefits. We also should be trying to do undertake more active policies to directly create jobs in the private and public sector and to provide employers with a little help and some incentive for hiring more long-term unemployed and disadvantaged workers. All active labor market policies work better when the labor market is tighter, when firms are on net expanding employment, and when job search assistance, labor market intermediaries, and employment program help employers to find appropriate workers, take chances on more disadvantaged workers, and expand hiring more rapidly. Every substitute you can think of for the Federal Reserve macroeconomic policy in terms of structural labor market policies is less effective, when we have a very weak labor market like today. In the extreme case of a very slack labor market, structural policies act more like a musical chairs game with little net employment impacts.

In conclusion, to give American families and many disadvantaged and unemployed workers a chance, the Fed should not put the brakes on today or anytime in the near future. Ideally, we need the Fed to continue the work it has been doing. Federal Reserve Board Chair Yellen clearly recognizes that there remains a lot of slack in the labor market and the Fed needs to continue focusing on its full employment mandate with little evidence of inflation being a near-term concern. Of course, we would benefit as well from less austerity and more infrastructure spending and assistance on the fiscal policy side as well.