Tag Archives: unemployment

Overshooting Unemployment Rate

In recent discussions regarding the Fed’s timing of raising the interest rate and stopping the QE, the possibility of overshooting the unemployment rate to make sure the the economy doesn’t slip back to the panic after the Fed’s move. What overshooting the unemployment rate means is that the Fed waits the unemployment to get below “natural rate”, let’s say 5.5 percent, to raise the interest rate. Advocates of overshooting say that by doing so, the economy can gain lost capacity during the recession, and slightly higher inflation and nominal interest rate can benefit the economy in terms of more monetary policy room to kick another panic.

This argument of overshooting unemployment rate is one of the fundamental macroeconomics topics Milton Friedman addressed in his 1967 American Economic Association speech, titled “The Role of Monetary Policy”. According to him, lower than “natural” rate of  unemployment can be achieved through only increasing inflation. The key word here is increasing, since at the moment when he gave the speech, there was spreading view that there is trade-off between higher inflation and lower unemployment. Friedman argues that when the central bank raises the quantity of money supplied by buying bonds, it increases the money supplied higher than the amount people want to hold; therefore, it reduces the nominal interest rate and increase demand for goods. Companies would respond to increase in demand by first supplying more of the goods without increasing the prices. But eventually price would adjust to the demand by rising. At the same time, wages doesn’t rise as much as the price rises. Therefore, real wage would be decreased during this phase. 

Decreasing real wage would lead to higher employment. This is why we could see higher employment or lower unemployment through unexpected inflation rise. However, once the workers starts including the higher inflation rate to decide what wage to receive, they demand higher wages. Since the unemployment was lower than natural rate and the higher wage demand, the real wage starts increasing. The increase in real wage would then increase unemployment back to the normal level. If then the policymakers still want to pursue lower than natural unemployment rate, they now have to increase the supply of money  at higher than previous rate. Hence, we could see increasing price level or inflation as this process goes on forever until the policymakers decides to not target unemployment rate lower than natural rate.

How this discussion relates to current policy making is that if the Fed decides to pursue the unemployment rate below natural rate, 5.5 percent in our case, permanently, the Fed will face a problem of increasing inflation. i believe, the Fed will pursue it for one or two years if it indeed decides to it. Even though one or two years isn’t permanent, it is neither temporary. Therefore, the Fed will face some inflationary pressure. Some might say there won’t be high inflation since we are having low inflation now, but at the moment we pass the natural rate of unemployment, say 5.5 percent, the inflation will be back to the level of normal times.

When making decision of pursuing a low level of interest rate even after the unemployment rate reaches natural rate, the Fed policy makers should calculate the risk of increasing inflation.

U.S. Jobs Report

Yesterday, the US released their monthly job report for the month of March.  The report stated that 192,000 jobs were added due to the warmer weather.  The unemployment rate though has stayed constant at 6.7% as more people who weren’t looking for work started looking for work again.  The jobs growth was led by strong gains in the professional, business services, health and education.  According to the report, private payroll now exceeds the December 2007 pre-recession levels.  Another advantageous report is that January and February total jobs added was increased by 37,000.  The share of people looking for work rose from 62% to 62.3%.  While the share of people looking for work increased a little bit, it’s low level still worries economists.  Economists worry that a large number of these workers aren’t retirees, but discouraged works.  The lagging employment market was believed to be created by the excessively cold winter temperatures and massive snow.  The jobs added in march were greater than the 141,000 average jobs added from December to February.  Economists point to the higher interest rates and reduced production due to large business inventories are slowing down the economy and the labor market.  While some economists are pessimistic, the US has finally added enough jobs to replace the 8.8 million jobs that were lost due to the recession.

While the jobs report was mostly optimistic, many questioned where a large number of the workers have gone.  While the unemployment rate has dropped from the 10% high during the great recession to 6.7%, the labor force participation rate, at 63.2%, is at its lowest point since 2000.  The questions now becomes, how does the economy create incentive for participants to rejoin the labor force.  Unfortunately, market sentiment right now among the labor force is still pessimistic.  Economists worry that the drop in participants is not just a cyclical phenomenon but a structural problem.  Unfortunately, I believe that right now it is a structural problem.  The fact that participation hasn’t increased while unemployment has decreased and monetary policy hasn’t necessarily fixed the lack of participation while the economy is picking up steam again.  The major evidence is that employment is increasing while participation is decreasing.  Before the recession, employment increasing usually meant that participation was increasing.   The Fed in Chicago believe that only 1/4 of the drop in participation can be attributed to the retiring of the baby boomer generation.  This means that other, structural factors are at play.  In order for the US to achieve full employment again, we first need to determine whether the drop in participation is structural or cyclical.

The End of Forward Guidance

In December 2012, The Federal Reserve declared “it would not raise interest rates until America’s unemployment rate dropped to at least 6.5%, so long as inflation remained below 2.5%.”  This declaration represents one of the Fed’s most powerful tools for impacting economic conditions at the zero lower bound: forward guidance.

Forward guidance describes a promise of future monetary policy in order to impact current economic activity.  Today, the Fed employs forward guidance by promising to keep interest rates low until a 6.5% unemployment rate is reached.  Doing so increases investor confidence because investors know that interest rates will not increase until unemployment hits 6.5%.  With a good estimate of future interest rates, investors feel safer making investments now.  In turn, this heightened level of investment increase economic output and accelerate economic recovery.

Forward guidance is not a new tool.  In the 1990’s the Bank of Japan promised to keep interest rates at zero “until deflationary concerns subside.”  In the United States, the Fed cut interest rates to 1% in 2003 and pledged to keep rates at this level “for a considerable period.”  While forward guidance has certainly evolved since the Great Recession (from vague statements about time to concrete thresholds determining policy decisions), the zero lower bound necessitates its use even today.  Unable to lower short-term interest rates to their necessary, negative rate, forward guidance allows the Fed to impact long-term rates and long-term risk tolerance in an effort to stimulate the economy.

That said, recent debate has me worried about the legitimacy of forward guidance.  As the unemployment rate nears the 6.5% threshold targeted by the Federal Reserve, there is talk (and concern) about hikes in interest rates.  In my opinion, once this 6.5% unemployment is achieved, the Fed should raise interest rates and keep its promise.  However an intriguingly titled Wall Street Journal article caught my eye this morning.  With the title “Grand Central: As Unemployment Falls, Fed Doves Pivot to Low Inflation Concern,” this article had me concerned as to whether the Fed will actually keep its promise to raise interest rates once 6.5% unemployment is reached.

The article notes that some Fed doves are concerned about low inflation rates.  In 2012, the Fed targeted an annual inflation rate of 2%, but in reality has only generated inflation of 1.3%.  As shown in the graph below, this discrepancy in rates has caused a discrepancy between predicted price levels and actual price levels.  Many doves support the continuation of low interest rates so as to boost short-term inflation above 2% and bring actual price levels in line with predicted price levels.

Screen shot 2014-03-24 at 12.00.01 PM

Personally, I have two issues with this decision.  The first relates to the motivation for boosting inflation to match actual and predicted price levels.  I agree that inflation can be helpful in the face of the zero lower bound by allowing for negative real interest rates and increased economic investment.  That said, once the Fed reaches its 6.5% unemployment target, its goals have been met, and there should be no further need for large economic stimulus.  At least, this would be the case if the Fed stayed committed to its December 2012 promises.

Which brings me to my second and more important issue with this decision: it undermines forward guidance, thereby challenging the trustworthiness of the Fed and potentially eliminating a powerful policy tool.  In my opinion, if the Fed does not alter the direction of interest rates after reaching a 6.5% unemployment rate (as many doves are suggesting), it is completely disregarding the forward guidance promises made in 2012.  Granted, while these promises were qualified by terms like “necessary” and “sufficient,” the Fed did commit to a policy change at 6.5%.  If the Fed does not change its policy after reaching this threshold, my trust in the Fed will be destroyed.  If private investors (whose decisions depend of trusting the Fed’s promises) are like me, they will also lose trust in the Fed, thereby eliminating forward guidance as policy tool.

Ultimately, forward guidance is a tricky tool as it locks the Fed into a single, long-term strategy.  Deviation from this strategy (which might occur very soon) undermines the Fed’s trustworthiness and eliminates forward guidance as a policy tool entirely.  In this way, effective forward guidance requires consensus as to the goals of central banks.  Today, there is frequent debate as to which metrics the Fed should target.  Some believe inflation should be the Fed’s key goal; others are more focused on unemployment and still others are focused on financial stability.  In my opinion, there will always be debate as to which metrics the Fed should target.  And I think there should be.  The Fed should not pick a single goal, but rather should address each economic situation individual to respond optimally.

For this reason, I believe forward guidance, while powerful, is a ridiculous economic tool.  It locks the Fed into a long-term strategy and inhibits its ability to respond to unanticipated changes in economic conditions.  Interestingly, the elimination of the zero lower bound would eliminate the need for forward guidance.  As such, I believe that addressing the zero lower bound should be a key priority for the Federal Reserve, as the Fed’s current need to use forward guidance hinders its ability to do its job well.

 

Making Sense of the Fed’s UE Target Drop

Lately, there have been uneven wage gains in the economy, which we have seen has had recent implications at the Fed. In some segments of the economy, wages have been booming. In others, many people have been left behind and have still suffered lower incomes now five years after the recession has ended. For example, there has been a surge in home building, which has driven up demand for skilled labor. Also, the trucking industry has a large proportion of baby boomers. Hence, they are expecting a larger amount of drivers to retire in the coming years so unequal wage gains will go to more experienced truck drivers.

Workers in blue-collar, largely skilled fields have been the lucky ones. They are able to receive top pay because of shortages of qualified workers and some blue-collar workers also have a willingness to take demanding jobs in remote areas. However, chances of the recovery actually picking up will occur when workers across more industries are able to secure wage gains. Stagnant incomes of Americans create a vicious cycle that leaves businesses waiting for stronger spending before they are able to increase hiring and investment. Just as we learned in class, higher spending is the way out of a recession.

At the Fed, officials have been monitoring wage measures to predict the health of the economy in order to make sound decisions regarding interest-rate policy. At Wednesday’s central bank policy meeting, Janet Yellen commented that wages are currently “signaling weakness in the labor market”. However, a debate emerged within the Fed regarding labor-market slack and upward wage pressures. This is evident through the fact that they recently dropped their unemployment rate target in order to account for other labor market measures. Ms. Yellen also commented that although one gauge of wage growth “suggests some uptick, most measures of wage increase are running at very low levels”. We can see the implications of these sluggish measures of wage increase through worker shortages in specific regions and occupations.

In my opinion, I think it was a good idea that the Fed dropped the unemployment rate target and I believe that it was done because it was an inaccurate measure of the current economy. In my last post, I commented on the other specific measures of the job market that the Fed is currently using. Many of the jobless people in the 6.7% figure are long-term unemployed who are unlikely to find jobs. Also, the 6.7% misses the Americans who want full-time work but are stuck in part-time work or gave up looking. With such contrasting measures included in the same percentage rate, it was a sound decision that the Fed look more carefully to other measures.

Undermining the Fed Through Minimum Wage

While reading The Wall Street Journal yesterday, I actually laughed at the content of one particular article.  The title was both intriguing and promising: “Just One Large City Saw Unemployment Rise From Last Year.”  Upon opening the article, I saw the graph shown below, with the title “Not Always Hot in Cleveland.”  As a Michigan fan, I laughed – just another reason why Ohio is an awful place.

Screen shot 2014-03-22 at 11.34.11 AM

But while my biases made this article funny, the content of the article was actually quite inspiring.  On a national scale, unemployment fell over 1% from January 2013 to January 2014.  And in bustling metropolitan areas like Charlotte, unemployment dropped by more than 2.5%.  This data seems to suggest that while the Fed’s easy money policy has been slow, it is indeed working.  Slowly but surely Bernanke, and now Yellen, are pulling America out of its hole.

Unfortunately, I believe the federal government is on track to undermine all the hard work that the Federal Reserve has put in since 2008.  By raising minimum wage to $10.10 from its current rate of $7.25, the federal government will likely slam the brakes on the Fed’s steady progress.  A recent survey by Express Employment professionals shows that of the businesses currently paying minimum wage, more than 50% would slow hiring in the event of a minimum wage hike.  Furthermore, 38% of these businesses would lay off currently employed workers.  According to the Congressional Budget Office, the proposed $2.85 minimum wage hike will cost the United States 500,000 jobs by Q3 2013.  At a time when employment is really starting to recover (except for in Cleveland), I am fearful that an increase in minimum wage will cause the economy to stagnate, thereby undoing the Fed’s hard work.

Screen shot 2014-03-22 at 11.34.24 AM

It is true that the Congressional Budget Office also predicts that an increase in minimum wage will help pull 900,000 Americans out of poverty by boosting income levels.  And certainly, reducing poverty is an extremely important goal.  However, I believe there are alternative ways to address income inequality that are less likely to undermine the stimulus enacted by the Federal Reserve.

I have already written numerous posts on addressing income inequality, and what I believe is a more important issue – income mobility.  (See “Using Skilled-Trade and Manufacturing to Rebuild the Middle Class,” “Drill Baby Drill: Addressing Income Mobility With Energy Production,” “Forget Minimum Wage – Let’s Talk about Wage Subsidies,” and “How New Immigration Policy Can Save America’s Economy“)

The majority of these posts focus on increasing the economic mobility of the poor so that they can have access to higher paying jobs.  I believe this type of policy is significantly better for the US economy because it avoids the level of deadweight loss that raising minimum wage will have.  Indeed, a boost to minimum wage is very similar to a tax, and the policies proposed in the articles above behave much more like subsidies.  While it is true that a subsidy, by definition, will cost the federal government more money than a tax, it is also true that a subsidy results in significantly less deadweight loss.  And at a time when the economy is just beginning to see the light of day, leaving any economic value on the table seems like a terrible idea to me.  For this reason, I strongly oppose raising minimum wage, at least currently, as doing so will undermine the efforts of the Fed, cause stagnation in employment rates, and hinder this country’s economic recovery.

Quite the Start for Yellen

Today was Janet Yellen’s first meeting as Chairwoman of the Federal Reserve. She announced that short-term rates were going to remain near zero. According to the Wall Street Journal, she is playing down the fact that rates are going to rise sooner than said. The article continues to say that investors are speculating that rates will increase a lot more aggressively. The New York Times covered the same story. Both articles mention the Federal Reserve’s decrease in the purchasing of bonds. In the article in the Times, the Fed has decreased its bond-purchases to $55 billion. The Fed is finally believing that the ongoing economic recovery is self-sustaining. Short -term interest rates will be kept near zero even after the unemployment rate falls below 6.5%.

The Washington Post covers this story from an unemployment perspective. It is true that the unemployment rate has been dropping. The article goes on to discuss that this is due to the fact that fewer people are working and trying to find work. This is another way of saying that the labor force is shrinking. This could be a false indicator of the United States economy becoming healthier.

This year, the Federal Reserve has introduced a tapering policy. That means that it is cutting back on its bond purchases, which is how it is attempting to stimulate the economy. When the Fed purchases bonds, short-term interest rates get closer to zero. The reason why the Federal Reserve is cutting back is that the economy is showing better signs of recovery. Investors believe that short-term rates will rise as this tapering continues. That makes sense, the Fed is stimulating the economy less.

I think that the employment situation directly applies to A Random Walk Down Wall Street. So, the unemployment rate has been dropping recently. At first glance, this would seem like a good thing because employment has been one of the greatest concerns in this economic downturn. In his book, Mankiel’s main point is that going by past and projected trends is not the best way to go about investing. An investment can go anywhere at any time. The same thing can be said about employment. Right now, it seems that the labor market is making its recovery. The fact of the matter is that there is another reason why the unemployment rate is going down. The labor force is shrinking in size. With a smaller labor force, then the number of people with jobs is a larger percentage of a labor force with fewer people. There is more than what meets the eye with the employment situation.

Fed Meeting: Staying the Course Spooks Markets

During the meeting of the Federal Reserve today, there were no surprises. According to the Wall Street Journal, “The Fed took several actions at the meeting. First, it pulled back to $55 billion from $65 billion its monthly bond-buying program, which is aimed at holding down long-term interest rates in hopes of boosting spending, hiring and growth. It was the third reduction in the bond purchases since December”. Asset purchases, which have been reduced from $85 billion a month, are on pace to be finished this coming October. Tapering and the ending (in the growth of) asset purchases was already priced into the market before the Fed’s meeting. In short, tapering is old news. Although asset purchases will likely be done in October, it remains to be seen how the Fed unwinds its massive balance sheet.

The Fed made some (relatively) more exciting changes with respect to forward guidance. According to the Wall Street Journal, “The central bank also rewrote its guidance about the likely path of short-term interest rates, putting less weight on the unemployment rate as a signpost for when rate increases will start”. As the unemployment rate has decreased to 6.7%, the 6.5% threshold for unemployment has become a less significant data point for policy makers. Furthermore, limitations of the unemployment rate have made it less meaningful as an indication of conditions in the labor market. I have mentioned in previous blogs that changes in the unemployment rate were not accurately portraying underlying conditions in labor markets . For example, an increase in the labor-force participation rate pushed the unemployment rate up to 6.7% in the last employment report. Although an increase in the labor-force participation rate is perceived as good, an increase in the unemployment rate is seen as bad. According to the Wall Street Journal, “It said instead [of the 6.5% unemployment threshold] that the Fed would look at a broad range of economic indicators in deciding when to start raising short-term rates from near zero, where they have been since December 2008“. Therefore, I believe it was a good decision to ditch the unemployment threshold in favor of a larger set of economic indicators.

In addition, the Fed reconfirmed its forward guidance on interest rates. According to the Wall Street Journal, “The Fed took several steps to assure investors that interest rates won’t rise soon and that when rates do start rising the increases will be gradual and limited. For example, the Fed’s official policy statement included a new line noting that officials expect to keep rates lower than normal even after inflation and employment return to their longer-run trends“. Although this policy has been understood for some time, the Fed has finally decided to state this unambiguously. As the Fed continues to taper, most people assume that rate hikes will follow – the question is how soon they will follow. In addition to other factors, the inflation rate is going to be important in determining when interest rates will rise. If inflation remains below target, then rates will remain low long after the bond buying ends.

However, financial markets fell today – possibly due to what was said during the Fed’s meeting. According to the Wall Street Journal, “Even though the Fed’s official policy statement sought to give assurances of continued low rates far into the future and Ms. Yellen played down rate-increase expectations, stock prices fell and longer-term rates on Treasury bonds moved up”. Despite the lack of surprises, the Fed’s meeting managed to somehow cause worry among investors.

Apparently, the source of concern was regarding the perception of imminent rate hikes. According to the Wall Street Journal, “In a press conference after the meeting, Ms. Yellen suggested that interest-rate increases might come about six months after the bond-buying program ends – a conclusion that could come this fall”. Financial markets were not anticipating interest rates to increase in early 2015. After many years of aggressive expansionary monetary policy, the financial markets have become very sensitive to interest rate decisions.

Today’s Fed meeting essentially affirmed that interest rates will begin rising in 2015. Considering that asset purchases will likely end in October 2014, interest rate hikes in 2015 might seem sudden to financial markets. Regardless, I believe interest rates will begin rising in 2015 so financial markets might as well begin pricing that in. According to the Wall Street Journal, “Ten of 16 officials saw short-term rates rising to 1% or more by the end of 2015, with four of them right at 1%. Six officials saw rates below 1% by the end of 2015“. Although Ms. Yellen might have misspoke during the press conference, I think it is good that she was very clear about when interest rates will begin rising. Assuming there are no setbacks, I believe the economy is strengthening to the point where interest rates can begin to rise.

Unemployment in Korea – what is the problem?

South Korea’s unemployment rate is an ongoing concern. When president Park Geun Hye (first female president in Korean history) was elected as president of Korea in 2013, she announced a three-year economic plan for “economic innovation.” This included increasing Korea’s economic growth rate to 4 percent, employment to 70 percent, and per capita income to $40,000, also known as “474” vision. Her goal is well explained in the article Sean Connell: Korea’s Creative Approach to Economic Competitiveness. Her first year of presidency passed by, and how is Korean economy right now?

According to the Reuters article South Korea unemployment rate hits three-year high in jobseeker surge, South Korea’s unemployment rate spiked to a three-year high in February. February’s unemployment rate rose to 3.9 percent from 3.2 percent in January. The main reason for increase in unemployment rate is due to 308,800 additional people entering the job market- college graduates. As only 112,800 jobs were newly created in February, the difference of 196,000 increased the February unemployment rate.

President Park Geun Hye tried hard to increase the employment, particularly among women and youth. According to Korea Joongang Daily’s article Survey traces gender employment, female employment in age of 30s was 57% in 2013. Park Geun Hye tried to increase the employment among this group by increasing the part-time employment, planning to create a total of 930,000 part time jobs by 2017, according to an editorial from the Korean Herald Part-time employment.

I think increasing the part-time job will benefit two groups. First, females who would like to go back to work after giving birth. Second, retired professionals who can still utilize their valuable experience and expertise in field. However, part-time employment is essential useless for new college graduates flowing into the job market. Therefore, although creating part-time jobs can decrease unemployment rate, it cannot solve the essential problem; lowering the unemployment rate of youth- the college graduates.

I expect that the unemployment rate will decrease as president Park Geun Hye’s plan for creating part time jobs continue. However, as many ECON 411 students have pointed out, number of jobs isn’t the only one that is important. Quality of jobs is as important as quality. Of course, creating quality full-time jobs could be beyond the government’s control. Firms, which the main goal is to maximize their profits, might not be tempted to hire more full-time employees. Therefore, I understand government’s plan to increase part time jobs first, but I strongly think that government should try their best to make policies that will enable firms to create more full time jobs. That’s the ideal way of decreasing unemployment rate.

Colorado’s Goldmine

As of January 1, 2014, it became legal for licensed stores to sell marijuana for recreational use in Colorado.  As of January 31, 2014, the Colorado state government had debited approximately $2 million in tax revenue from $14 million of recreational marijuana sales.  Combined with $1.5 million of tax revenue from the sale of medical marijuana, Colorado’s weed market is the envy of states everywhere, sparking new legislation proposals in Alaska and New Jersey.

Experts predict that if the current trend in marijuana use in Colorado continues, the state will collect over $40 million in revenue by the end of 2014.  This is certainly not a small sum of money.  To put this value into perspective, $40 million is approximately 1% of the total state budget for a smaller states like Delaware, Montana, and West Virginia.

What makes marijuana such an attractive market for state governments is weed’s relatively low elasticity.  Marijuana consumers are willing to pay a large premium for weed, allowing the Colorado government to add on a 13% total sales tax in some of the state’s more rural areas and over 20% sales tax in more urban areas like Denver.  In addition, the state charges retail locations a 15% sales tax when purchasing marijuana from local dispensaries. 

Recreational marijuana use will become legal in Washington later this year and by the end of 2014, the recreational marijuana market is estimated to be worth $2.34 billion dollars in these two states alone.  Given that Colorado extracted $2 million in tax revenue from $14 million of sales in January, legalization of weed in these two states could result in over $300 million of additional tax revenue each year!

This value-added analysis doesn’t even acknowledge the impact that marijuana can have on unemployment.  In January alone, Colorado issued 160 new licensees for marijuana businesses.  And between January and March, many of these businesses experienced over a 100% growth in their work force, growing from 5-6 employees per dispensary to 20 or more.  Indeed, over 600 people attended Colorado’s first ever marijuana-jobs fair this month!

Marijuana-related jobs are far more reaching than growing and selling marijuana.  At Colorado’s marijuana-fair, positions advertised included medicinal experts, web designers, chefs to make gourmet “edibles,” sales representatives, guides for marijuana tourism, and finance experts to help run all these new businesses.  While it is hard to estimate the total number of jobs that this nascent industry will bring to Colorado, it seems obvious that marijuana will be very helpful in helping Colarado lower its unemployment rate.

Ultimately, marijuana seems like an excellent opportunity to add value to the US economy.  Given the tax revenue it generates and the jobs it creates, marijuana really is a goldmine that the US government should take advantage of.  And as anyone who has studied prohibition knows, government bans do not eliminate markets but instead eliminate opportunities for tax revenue.  For these reasons, I strongly support the legalization of recreational marijuana use throughout the rest of the United States.

Why Do We Need Higher Inflation?

In my last post, I wrote about how the recent acceleration of wage increase might pose a question of more tapering to the FED. Appropriately enough, Paul Krugman happens to write a piece on the same topic on Wednesday. To sum up his main point, he argued that this recent wage-inflation shouldn’t bother the policy makers regarding their plan on raising interest rate timely. According to him, there hasn’t been a strong relationship between the unemployment rate and the rate of change of wage increase, but the level of wage increase. We can see that relationship from the following graph:

UNRATE_REALWAGEEven though we see a relationship between the unemployment  rate and the level of wage change, we can see even stronger relationship between the unemployment rate and the level of real wage change, measured by adjusting nominal wage change to core inflation rate. In the above graph, the relationship looks more robust since the early 80s recession. During 90s, the two curves look like an exact mirrored image of the other. The real wage has been increasing at higher rate when the unemployment was decreasing. But I cannot explain in this post is how much causation between the two and which one is leading to the other: is it low unemployment driving real wages up? or is it raise in real wage driving unemployment up?

Now, let’s turn to how inflation plays a role here. In his post, Krugman sums up benefit and cost of the FED’s move to mediate a possible wage-inflation. He says:

If the Fed stays calm about rising wages and lets the economy grow, the worst that could happen would be a modest rise in inflation by the time it becomes clear that the natural rate really is 6 percent or higher – and remember, a modest rise in inflation would arguably be a good thing. On the other hand, if the Fed tightens prematurely, it could end up trapping us in lowflation; essentially, it would have completed the Japanification of the US economy, putting us into a trap that’s very hard to exit.

If the FED goes to tighten the economy as people who are worried about the wage-inflation want, as Krugman said, we could see ourselves in very low inflation, which is not a good thing to the economy as we saw it in Japan. Therefore, the FED arguably shouldn’t play active against the possible mild wage-inflation and its possible effect on unemployment, but what the FED should do against this nominal wage-inflation is to bring enough inflation to keep real wage from inflating therefore holding unemployment high. And again as Krugman says, a way to reach modest inflation is by having modest nominal wage-inflation. In other words, higher inflation cuts the real wage providing a partial solution to downward nominal wage rigidity. How to get inflation rate above or same to the target inflation rate of 2% is a question central bankers are facing right now, but premature tightening is a mistake to avoid to get inflation up.