Balancing the risks and rewards of tight labor

admin | July 19, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The desire to help communities and families that have, until recently, not shared equally in the economy’s strength has led to calls for the Fed to let the economy run hot, a siren call that Chairman Powell seems to be at least considering. With inflation quiescent, it appears a number of FOMC participants have no fear at all of running an excessively easy monetary policy. That raises the probability of a policy error and makes the Fed more prone to political influence.

Last in, first out

 The Fed has signaled interest lately in some of the subtle benefits of tight labor. It is well-known that in business cycles lower-skilled workers tend to suffer the most when the economy turns down and are often the last to benefit as the economy recovers.  That phenomenon has been especially true in the last decade.  Lower-skilled workers were hit extremely hard during the Great Recession and only saw gradual improvement in job prospects through much of the expansion.  However, as the labor market has gotten tight in recent years, lower-skilled workers have begun to be among the chief beneficiaries, as unemployment rates and wage increases have improved the most for this subset of the labor force in recent years.

It is quite intuitive that those on the lower end of the skill spectrum will be among the first to lose their jobs when the economy turns down, as firms try to hoard their most valued employees and are forced to let go of the more expendable workers when business slows.  Conversely, when a recession ends and growth resumes, unemployment is typically high and, as a result, firms have ample choices to fill their openings.  They may choose to raise their standards, perhaps requiring a college degree for a job that does not truly need one.  Thus, those with fewer skills to offer often are frustrated in their job search processes, repeatedly beaten out by individuals with more attractive resumes.  As the labor market normalizes, labor shortages initially tend to show up as isolated instances in highly specialized skilled positions.  It is only when the unemployment rate falls to low levels economy-wide that those toward the bottom of the skill spectrum begin to fully experience the benefits of vigorous labor demand.  Usually by the late stages of a strong expansion, labor shortages stretch across all skill levels.  For example, in the late 1990s, there were “help wanted” signs in virtually every retail and restaurant window and widespread reports of erstwhile retirees working at fast-food restaurants.

Reaching the sweet spot

The evolution of the current expansion has tracked that pattern well.  Labor shortages began to show up several years into the recovery but only as isolated cases involving highly-specialized skills.  As the unemployment rate has continued to fall, the surplus of demand for workers over supply has extended throughout the skill spectrum.

In the Federal Reserve’s semi-annual monetary policy report to Congress, released earlier this month, the Board staff included a chart showing employment-to-population ratios and real wage movements by educational attainment. The Fed Board staff’s calculations show that for prime-age workers with a college degree or more, the employment-to-population ratio bottomed out in 2010, about the time that overall payrolls began to turn up.  In contrast, for those with a high school degree or less, the employment-to-population ratio continued to fall for another year or two and rebounded only marginally for a time after that.  The employment-to-population ratio only began to recover rapidly in 2016, i.e. in the seventh year of the cycle, and has been closing the gap since then.  Even so, in 2018, while the employment-to-population ratio for highly educated workers had basically returned to its 2007 level, the corresponding figure for less-educated workers was still over 2% lower than in 2007.  Based on the trajectory of the past few years, it may take another two or three years to get back to the 2007 reading, by which time the expansion would be about two years longer than the previous record.

Similarly, Fed Board staff calculations show that real wages fell by more from the 2007 level through 2013 for lower-educated workers than for those with a college degree or more.  In fact, through 2013, the cumulative drop in real wages was nearly three times as large (-4.2%) for less-educated workers than for highly-educated workers (-1.5%).  As the labor market has tightened, real wages for less-educated workers have actually accelerated noticeably faster than for more highly educated employees.  In fact, by 2018, the gap that opened up early in the expansion had entirely closed.

The Atlanta Fed’s wage tracker data show a similar story.  The Atlanta Fed collects responses from the BLS’s household survey and tracks the change in wages for specific households over a 12-month period.  The sample size is smaller than for the aggregate average hourly earnings figures, but the Atlanta Fed data represent an apples-to-apples comparison of wage gains for specific individual households rather than being subject to a shifting mix of respondents. Exhibit 1 shows the Atlanta Fed wage tracker data broken down by occupation.  Wage gains for low-skill occupations were nearly stagnant for nearly five years after the recession ended, even as wage advances for higher-skilled occupations were gradually accelerating. However, as the expansion matured and overall unemployment fell, low-skilled occupations began to catch up.  Exhibit 1 shows that wage gains for low-skilled occupations performed especially well in 2018, accelerating by close to a full percentage point, essentially closing the gap with higher-skilled job descriptions.

Exhibit 1: Wage growth tracker by occupation

Note: 12-month moving averages of median wage growth. Source: Federal Reserve Bank of Atlanta, current population survey, Bureau of Labor Statistics and calculations by Atlanta Fed staff.

What is the Fed to do?

Monetary policymakers have historically been looked upon as miserly.  As Fed Chairman William McChesney Martin put it in 1955, the Fed’s job is “to take away the punch bowl just as the party gets going.”  However, in recent years, Fed leadership has adjusted its tone, perhaps bending to the politics of the day and/or to the fact that inflation seems more under control than it did in past decades.  In any case, Chairman Powell has continued a pattern that I first noted under Chair Yellen of citing statistics like unemployment rates for different communities in describing economic conditions, even though the Fed is broadly powerless to directly aid one group over another. The last two Fed Chairs have made an explicit point of emphasizing the gains that have accrued to those in the bottom reaches of the income and skills spectrum, perhaps attempting to garner political support for their relatively easy policy stances.  As someone who came of age in an earlier era when the Fed was primarily focused on controlling inflation, I have to admit that the image of Fed officials as social justice warriors is hard to adjust to!

The key policy question for the Fed to how hard to press the economy in an effort to broaden the benefits of a strong economy and a tight labor market.  Several members of the FOMC have suggested that in the absence of a sharp acceleration in wages and/or prices, the Fed should run an easy policy to extend economic gains for those who most need the help.  At many of the recent Fed Listens events, officials are talking to community leaders, labor union officials, and others who are pressing for easy policy.

However, the Federal Reserve’s mandate is maximum sustainable employment.  Pushing the unemployment rate to levels last seen in peacetime in the 1920s will make many people happy in the short run, but as we learned in 1929 and again in 2000 and 2007-08, when the Fed leaves the punch bowl in place too long, the economy can end up with a massive hangover.  As I have noted, Chairman Powell has systematically torn down the guard rails that have historically governed the conduct of monetary policy, dismissing concepts like the natural unemployment rate and an equilibrium interest rate as too difficult to estimate to be of any practical use.  The result is that the Fed has no tangible framework for assessing whether the economy is overheating or policy is too easy, which raises the probability of a policy error and makes the Fed more prone to political influence.