The Real Reason the Fed Has Been Hiking

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Around this time last year, I wrote: “Stronger-than-expected wage growth will make the Fed see inflation, tighten policy more than presently expected, and probably send stock prices lower.”

Sure enough, the Fed tightened more than people thought it would. And stock prices indeed dropped.

But I also said the best long-term outcome of higher wages was to help workers recover their purchasing power. Even if it meant short-term stock declines.

In reality, we got the bad without the good. The Fed tightened and stocks fell. But the average worker saw little or no real wage growth.

It wasn’t supposed to work this way.

Why the Fed Doesn’t Want Wage Growth

Bigger paychecks seem like a good thing.

Better-paid workers save and spend more, helping the economy grow. The government gets more tax revenue. Even employers like higher pay if it brings more productive workers.

However, the Federal Reserve doesn’t think that way. Its job is to promote

  • Maximum employment
  • Stable prices
  • Moderate long-term interest rates

Higher wages conflict with those goals if businesses raise prices in response—i.e., inflation. So when the Fed sees pay rising, its reflex is to “tap the brakes” by raising interest rates.

That’s what happened in 2017 and again in 2018.

The Fed raised interest rates not because it saw low unemployment and figured higher wages would be right behind.

But that wasn’t the case…

Wage Gains Were Little to None

The Labor Department says average hourly earnings rose 3.2% in 2018. Meanwhile inflation (through November) was up 1.9%. That means wage gains after inflation were only 1.3%.

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Yes, this wasn’t the case for everyone. It’s a national average. Some people did better than average, others worse.

But it appears the latter group was bigger.

In a November Bankrate survey, 62% of employed Americans said they hadn’t received a pay raise or taken a better-paying job in the last year.

If this data is right, 2018 wage gains were mild and affected only one-third of the workforce. The rest still made the same as a year ago (or possibly less).

So, Why Is the Fed Tightening?

Now, does this look like an overheated economy that needs cooling? I don’t think so. But the Fed is cooling it anyway.

Here’s what the Federal Open Market Committee (FOMC) said in the minutes from its November meeting:

Participants observed that, at the national level, measures of nominal wage growth appeared to be picking up. Many participants noted that the recent pace of aggregate wage gains was broadly consistent with trends in productivity growth and inflation.

Let me decode this for you.

“Nominal” wage growth means growth before inflation. Which is picking up, as I noted above.

“Broadly consistent with trends in productivity growth and inflation” is more unclear.

They seem to be saying wages aren’t really changing much given added productivity and inflation. Which is also true.

But it isn’t an argument for rate hikes, so why say it?

I think the answer is that the Fed’s real goal in raising rates is to be able to cut again in the next recession—which may not be far away. If that restrains wage growth in the meantime, the Fed thinks it’s the lesser of two evils.

See also  Three charts of the UST 10Y. With bonus ominous trend line. Is this the reason for recent strength?

The Labor Market Is Broken

This isn’t a new or recent problem. Wages have lagged for most American workers for decades now.

American worker pay, adjusted for inflation and hours worked,  peaked in the early 1970s, bottomed in the mid-1990s, and has been slowly climbing back ever since. It is still below where it was 50 years ago.

Hard to believe? It’s true other things have changed as well. For instance, non-cash fringe benefits are a bigger part of compensation now, but those are getting scarcer too.

So I doubt they change the broader point: The US labor market is broken. Working hard and improving your skills doesn’t deliver the American Dream for most workers. And it hasn’t for a long time.

It’s no surprise people are angry and demanding change. Thus far, it has not appeared. Monetary and fiscal policy are arguably making the average worker’s situation worse, not better.

What will 2019 bring? We’ll find out. But unless it includes widespread and significant wage gains, I don’t expect much big-picture improvement this year.

That is a problem, even if you are a wealthy investor. Stock prices are the present value of expected future earnings, which will materialize only if consumers can afford what your company sells.


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