Fed is behind the curve…

Tim Duy wrote in a post titled, Inflation, Wages and Policy

“The fact that wages are rising while unemployment remains high is probably something of a puzzle to them (the Fed), and lends credence to the stories that the labor market is currently affected by severe structural issues…”

The explanation of wage growth uses structural issues, but there really isn’t strong structural unemployment signs. My view is that the economy has much less available spare capacity than is thought. It only appears as structural because they are assuming a large output gap.

So it is not that the Fed is currently behind the curve, but that the upturn in wage growth will make them worry that they will need to act to prevent them from falling behind the curve.  It is also another reason why they want to extract themselves from QE as soon as possible; they want to be prepared to act quickly should they find they took an overly dovish view of the labor market.  I think there is a lot of uncertainty regarding unemployment/wage/inflation dynamics at the moment, and that uncertainty is not making the Fed happy given the size of the balance sheet.”

The wage growth is telling a story that the labor market is reaching its natural rate of unemployment. It is no puzzle. The natural level of output has fallen and the natural level of unemployment is higher too. The wage growth is a natural sign that the economy is reaching the end of the business cycle.

The Fed is definitely worried. They want to extract themselves from QE as soon as possible. Many expect the Fed to get out of QE near the end of 2014, but it would be better if they were out of QE by July. The Fed should reduce QE by at least $15 billion per month, instead of $10 billion.

The size and nature of the Fed balance sheet is a problem though. If the economy heats up from wage growth before the Fed expects it to, there is inflationary potential.

Also, the Fed has to be careful. There is risk on its balance sheet. See this video by Perry Mehrling. (from 26 to 32 minutes he points out some risk on the Fed balance sheet.) I would also suggest viewing the portion from 1:10:20 to 1:15:30 minutes where he shows how the Fed indirectly put swaps and derivatives on its balance sheet to backstop risk markets.

Perry Mehrling mentions briefly that the new Fed balance sheet must succeed or else there could be world-wide depression. The one organization that you do not want affected by contagion is the Fed, and they do have some exposure at the moment.

Other economists (Simon Wren-Lewis for one) still say that “real interest rates are above their natural level because nominal interest rates cannot be negative.” As we learn that the output gap is much smaller than thought, we will also learn that real interest rates are lower than the natural rate of interest, not higher. (I talked about this in a video.) In time, we will learn the Fed is already behind the curve.

Comments (4) | |