Following another underwhelming U.S. CPI report, it’s now entirely possible that core personal consumption expenditures (PCE) inflation – the Federal Reserve’s preferred measure, currently at 1.5% – will end the year at 1.3%, a far cry from the central bank’s 2% target. Against this backdrop, the Federal Open Market Committee’s (FOMC) 1.7% median forecast for year-end PCE inflation (revised down from 1.9% only in June) increasingly looks like wishful thinking and will likely have to be revised lower yet again in the September projections.
Dovish turn looks more likely
With inflation continuing to underwhelm, odds are also growing that come September, the FOMC will throw in the towel on the additional rate hike that the majority of participants have penciled in (according to the “dot plot”) for the remainder of this year. The FOMC could justify its plan to delay further hikes by citing the need to wait and see how inflation develops or the need to minimize any negative market impact from the likely September announcement that a gradual reduction of the $4.5 trillion balance sheet will commence in October (though this should be largely priced in by now).
However, a dovish adjustment of the Fed’s projected rate path in September is nowhere near a done deal. This is because a majority of FOMC participants continue to believe in the Phillips curve and thus in an eventual pickup in wage and price inflation if unemployment is allowed to drop far enough.
I have several issues with this argument:
For starters, nobody can definitively state the magical level of unemployment below which wages start to accelerate sharply (in economists’ jargon, the non-accelerating inflation rate of unemployment, or NAIRU). The Fed, along with everybody else, has repeatedly had to revise its estimate of the NAIRU lower, and another such revision appears to be in order for September. True, unemployment is down to the lows reached in previous cycles. However, the lack of wage pressures suggests that significant slack may still be hidden in the labor market.
Second, even if it turns out that we are at or below the NAIRU and wage growth starts to take off for a majority of workers, I’d argue that this is exactly what the doctor ordered for an economy where the labor share in GDP has been shrinking and wage inequality has been increasing for decades. You don’t have to follow Marx (Karl, not Groucho) to realize that it’s time for some reverse redistribution that strengthens the median household’s purchasing power, reduces income and wealth inequality and thus keeps more radical populist tendencies at bay.
Third, even if wage growth should accelerate, I don’t believe this would necessarily lead to higher consumer price inflation. In fact, the evidence linking wages with inflation is weak at best. One reason is that higher wage growth may simply be absorbed in profit margins and thus prompt a decline in the profit share of GDP. Another possibility is that stronger wage growth will stimulate productivity growth and thus won’t increase (or will damp a rise in) wages per unit of output. This could happen if higher wages induce workers to work harder – a theory known as “efficiency wages” that incidentally was championed by present Fed Chair Janet Yellen and her husband George Akerlof, now a Nobel laureate, back in the 1980s. Also, productivity growth would pick up if higher wage increases induce companies to invest more in productive capital.
Fourth, even if inflation starts to rise in response to lower unemployment and higher wage growth, so what? Inflation has undershot the Fed’s target ever since the 2% objective was officially announced in early 2012. Overshooting the target for some time should thus not be a problem – it would only compensate for past failures. It could help to lift market-based inflation expectations back to the target and would provide more of a cushion against deflation if and when the next big adverse shock hits.
Run it hot
All said, I think it’s high time for Janet Yellen and the Fed to run the economy a little hot. And the Fed wouldn’t even have to go to great lengths to explain it: Yellen already laid out the rationale for running a “high-pressure economy” at a speech in Boston in October 2016. It’s worth a re-read!
For insight into how PIMCO is positioning for these and other potential policy pivots, please read our Asset Allocation Outlook Midyear Update.
Joachim Fels is PIMCO’s global economic advisor and a regular contributor to the PIMCO Blog.