For years, Fed watchers have been getting antsy as unemployment falls toward NAIRU — the Fed’s estimate of the bound below which inflation rises. But as shown in the graphic above, each time unemployment has threatened to break through NAIRU the Fed has lowered NAIRU rather than raise interest rates. Why?
The answer would appear to be in wage growth. As shown in the small inset graph, there is a strong relationship between wage growth and slack in the labor market—as measured by the difference between unemployment and the Fed’s NAIRU estimate. What this suggests is that the Fed has consistently overestimated wage growth, leading it to lower NAIRU when new wage data come out.
As the yellow highlighted part of the graphic shows, we appear to be at a turning point. Unemployment is now near the bottom of the Fed’s NAIRU range. This supports the case for Fed rate hikes.
But beware. Though the Atlanta Fed measure of wage growth remains strong, at around 3.5 percent, it is slowing. Should it fall to 2.5 percent, we can, on past experience, expect the Fed to lower NAIRU again, such that its measure of labor market slack rises from zero to as much as 0.8 percentage points. That would mean putting rate hikes on hold.
This is a Hedgeye Guest Contributor piece written by Benn Steil and Emma Smith and reposted from the Council on Foreign Relations’ Geo-Graphics blog. Mr Steil is director of international economics at the Council on Foreign Relations and author of The Battle of Bretton Woods. It does not necessarily reflect the opinion of Hedgeye.