At the start of the year, we asked our senior advisers to identify what they see as key themes in the outlook for this year. Alan Krueger focuses on issues related to the labor market and inflation dynamics and his views have important implications for the FOMC’s policy strategy and the pace of rate hikes. First, he expects wage inflation to jump this year, reflecting the sensitivity of wage inflation to declines in the unemployment rate to below 5½%. Second, he sees an important pass-through of wage inflation to price inflation, suggesting an upside risk to inflation. Third, he expects the FOMC to be disappointed to the extent they expect a hot labor market to yield benefits in terms of unwinding adverse labor force participation effects following the Great Recession.
The labor market is approaching full employment. Janet Yellen acknowledged this fact at her press conference following the December 2016 FOMC meeting: “with a 4.6 percent unemployment and a solid labor market, there may be some additional slack in labor markets, but I would judge that the degree of slack has diminished.” The tightness of the labor market is already generating real wage growth in line with historical expectations.
My preferred specification of the wage Phillips Curve relates expected real wage growth – measured as wage growth this year less core inflation last year – to the unemployment rate. As the chart below shows expected real wage growth has been right around what one would predict with the unemployment rate falling below 5 percent last year. In 2015 and 2016 real wage growth was around 1 percent. Nominal wage growth has also begun to pick up. I suspect that in 2017 the dynamic of a tight labor market and rising wage pressures will put upward pressure on price inflation.
Indeed, I have said for a while that labor market slack is diminishing and that the unemployment rate continues to be the single best measure of labor market tightness. The principal argument against this view is that labor force participation has fallen so much that there is hidden slack because many of those who have left the labor force can come back if things really heat up. While there may be some hidden slack lurking in discouraged workers, historically labor force participation is only weakly procyclical, and there is no tendency for those who are out of the labor force to return to the labor force in greater numbers when the economy picks up, as the graph below shows. The very modest rebound in labor force participation that occurred from September 2015 to March 2016 was mainly a result of the unemployed staying unemployed longer, and that blip has mostly been reversed in recent months. The share of the unemployed who are long-term unemployed continues to be very high by historical standards, and I suspect we will see renewed labor force withdrawal of the long-term unemployed in the months ahead.
Barring a major shock – which certainly is in the realm of possibility with the incoming President’s inchoate, unconventional, and inconsistent views toward the economy – the U.S. labor market seems to me to be on a fairly steady path to recovery and full employment. I expect the unemployment rate to continue to fall and wage growth to gradually accelerate in 2017. For example, I could see the annual growth rate of the Employment Cost Index rising from around 2.25 percent at the end of 2016 to 3 percent or higher by the end of next year. This cost pressure could well put pressure on price inflation, as costs are passed on to consumers, so I see some upside to forecasts of core inflation in 2017. After 2017 is another story, however, as the new administration’s economic policies will be in place, productivity growth could rebound or continue to edge down, the composition of the FOMC will shift, automatic stabilizers (progressive income taxes, unemployment insurance, food stamps, health insurance subsidies, etc.) are likely to be weaker, and the economy will be subject to new shocks.