« Investor Behavior for Beginners | Main | David Sanger of the New York Times Takes a Dive (Why Oh Why Can't We Have a Better Press Corps? Department) »

June 13, 2005

FedSpeak

Kevin Drum writes:

The Washington Monthly: JUDGING THE ECONOMY.... Max Sawicky enters the fever swamp of mainstream economics and produces the following anecdote:

An econ professor I know likes to tell a story of his days as a Fed employee. At some kind of meeting new numbers were reported, to the effect that real wages had declined in a recent period. He recalls that a cheer went up among those present.

Business reporters do the same thing. Whether this is because they're equally clueless or because they're just following the crowd, I couldn't say.

There's a broad basket of economic indicators that we'd all like to see going in the right direction. We all want high GDP growth, low unemployment, a rising stock market, low inflation, etc. etc. But if you put a gun to my head and told me I could judge the health of an economy by only one statistic, my choice would be median income. If it's going up in real terms, the odds are good that the economy is in fine fettle. If it's stagnant or dropping, trouble is brewing. After all, what's the point of all the other stuff if 80% of the country isn't getting any benefit from it?

If I had been among those cheering when disappointing real wage growth was announced, it would have been because of the following chain of reasoning:

  1. Real wages are still lagging behind productivity.
  2. That means unemployment is still above the natural rate.
  3. That means the Federal Reserve can pursue policies to expand employment without worrying about accelerating overall inflation.
  4. It can cut interest rates.
  5. And so allow employment to expand rapidly.

When real wages start rising faster than trend productivity growth, it's a sign that inflationary pressures are or are about to start building. It's a sign that--as long as the Fed wishes to maintain its credibility as the guardian of effective price stability--it isn't going to be able to let employment grow rapidly for much longer.

So if I were to cheer at receiving news of disappointing real wage performance, it would be because I thought it told me that the natural rate of unemployment was lower than I had thought, and that the economy had more room to boom than I had thought.

Of course, bond traders don't think that far: they cheer at falling real wages and rising unemployment because the Fed's response to them is to cut interest rates and so elevate bond prices, and they are long bonds.

Posted by DeLong at June 13, 2005 09:23 PM