Oregon Office of Economic Analysis

This morning, Janet Yellen delivered her first keynote speech as Chairwoman at the Fed’s annual Jackson Hole symposium .  No real surprises in the speech, however she brought up one very interesting possibility/thought exercise which we will get to in a minute. First, the baseline for Fed policy remains that even as the headline unemployment rate continues to fall, not all is well with the economy. Significant slack remains even as measures like long-term unemployment and part-time for economic reasons are improving, they are still high. Additionally, the rate of hiring by firms and quits by workers are just now returning to levels seen during the depths of the 2001 recession. So, improvements are seen in the data and the economy is getting there, however the recovery is not yet complete. Furthermore, expectations that “next year” will be better have yet to materialize so far.

One area where most economists agree is that in order to see sustained inflation, you need stronger wage gains. So far, wages have kept up with the rate of inflation, but not much more than that. Here in Oregon the average wage, after adjusting for inflation is 1 percent higher today than just before the onset of the Great Recession. Mathematically this works out to an annualized 0.16 percent over the past six years. And that’s the average wage. Median wages are flat or down in real terms in Oregon and median household income across the country remains lower.

This subdued wage growth is exhibit A for most arguing about the slack in the economy. A tight labor market usually results in stronger wage gains as employers have to compete for the best workers. However, when the pool of candidates from which to choose remains large (due to high levels of unemployment) then employers do not need to compete, at least not as much.

This brings me back to Yellen’s speech this morning. She brought up one interesting possibility when it comes to the slow wage gains. She notes that this “may reflect the phenomenon of pent-up wage deflation…” due to downward nominal wage rigidity. That’s a lot of economic speak in a sentence, so let me try to explain in plain English.

Businesses probably would have liked to cut workers’ pay during the recession. However given that nobody likes to see their paycheck/wage decline, business chose to cut their hours back or to layoff some workers. Additionally, given the weak economy, businesses have not had to raise wages to keep their own workers or to attract good employees, given other job opportunities have not been plentiful.

So, do we have any evidence of this? Yes. The Federal Reserve Bank of San Francisco examined wage growth a couple years ago. Here you can see what workers actually received in terms of wage changes, compared with a normal distribution. Relatively few workers saw outright wage cuts, however many more than expected saw zero percent wage growth. This is what downward nominal wage rigidity looks like in practice.

Let’s return now to the Oregon average wage graph at the beginning. Notice what occurred in the early 1980s. Real average wages in Oregon dropped about 5 percent from the late 1970s to the mid 1980s. What Yellen is saying is one potential possibility is that firms across the U.S. may have preferred to respond like that to the Great Recession. Instead they have given out very small wage gains, however after years of zero to little wage gains, the relative position of firms may actually not be dissimilar. Labor costs are low, labor income as a share of the economy is low, etc, so firms have repositioned themselves without having to cut individual wages outright.

Chair Yellen’s point is that if this is true, then looking at wage growth alone may mask the amount of slack in the economy. We may be closer to full employment than we think. However, given the plethora of other data that indicates there remains slack, this is likely just a thought experiment and a good one for Friday musings. But we should continue to pay attention to these wage trends and on the bright side, if it is true, then stronger wage gains for workers should be coming in the near future, as it means economic slack is smaller than the Fed and most economists currently assume.