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Tell the FED stop raising interest rates: Wage growth will not cause inflation

Written By | Nov 4, 2018

WASHINGTON: The Bureau of Labor Statistics just released good news and bad news about wage growth. The good news is that wages grew at a 3.1 % rate in the last twelve months. The bad news is that wages grew at a 3.1 % rate in the last twelve months.

The Good News

The news is good since most Americans get most of their income through wages.  The average worker hasn’t seen a 3.1% annual increase in almost 10 years.  This wage increase coupled with the lower tax rates passed by Congress last year will result in more disposable income for consumers.

Most of that increased disposable income will be spent, adding billions of dollars to consumption.  This will add more growth to the economy and improvements in the standard of living for wage earners.

The Bad News

The news is normally considered bad too, especially today considering the Federal Reserve’s (FED) Monetary Policy.  The FED sees higher wages as increasing the cost of labor to business.  That usually means business will have to raise prices in order to maintain profit margins.  This results in inflationary pressure.

What are the goals of Monetary Policy?

Overall, FED policy is geared toward

  • Price stability (inflation less than 3%),
  • Economic growth ( the historical average is 3% to 3 ½% annually) and
  • Full employment (unemployment under 4%).

Keeping inflation low is their primary focus today.

In 2008, the economy was in deep recession.  The Fed began to focus on economic growth and full employment. The money supply was vastly increased and interest rates were lowered to near zero. This monetary policy ended the recession and started a recovery.

Obama administration actions to cure perceived social injustices worked against economic growth.

The Affordable Care Act (ACA) raised taxes on households and increased labor costs for business.  The Dodd/Frank bill severely restricted a bank’s ability to make loans.  (The Dodd-Frank Act Explained.)

Raising the Capital Gains tax rate and raising the income tax rate on the highest income earners reduced capital formation. Thousands of regulations increased costs to business.

As a result of those growth-stifling policies, the recovery that the FED started in 2009
didn’t lead to an expansion until the Trump administration reversed almost all
of the Obama Administration’s policies.

Once growth stifling regulations were removed, tax rates lowered, and parts of both Dodd/Frank and the ACA were repealed, the economy finally entered an expansion.  Currently, the growth rate is above 3.5%.

Is inflation a problem to worry about today?

The FED is now concerned about inflation.  They raised interest seven times in the last two years.  With this new information on wage growth, most economists are concluding that the FED will raise interest again when they meet in December and be equally aggressive next year.  That will tend to slow economic growth, which is exactly the wrong thing to do during the second year of expansion.

Besides, the current increase in wages will not be inflationary, simply because labor costs won’t increase substantially.  That’s because productivity is increasing.

Wage rate increases drive up labor costs only when then far exceed productivity.  In other words, suppose a worker earns $100 per day and produces 100 units of output.  The labor cost is $1 per unit.  If the worker gets a wage increase to $103, but still produces 100 units of output, the labor cost is $1.03 per unit.

But if the worker increases productivity by 3%, there are 103 units produced.  Paying a worker $103 to produce 103 units still results in a labor cost of $1.00.

Workers’ productivity is going up.

Since productivity grew 2.2% in the third quarter,  the 3.1% wage growth will add, on average, less than 1% to labor cost and a lower amount to finished goods prices.  That means the wage gains will not have a significant impact on future inflation. Going forward, productivity is likely to see even greater increases.  The good news is, that will lead to wage growth even higher than the 3.1% recently reported.

Because Congress geared the 2017 tax cut to create new capital, our capital-intensive economy will be able to grow while enabling workers to substantially increase their productivity.  The new capital means the capital/labor ratio will increase.  This results in each worker having more capital goods to use in the production process. That increases worker productivity.

Both non-inflationary economic growth and worker productivity could grow
even faster if Congress would reduce the capital gains tax rate back to 15%.
This should be considered for Tax Cut 2.0.

Since future wage increases will not be inflationary and since the supply-side tax cuts will enable businesses to keep up with demand, there should be little inflationary pressure.  The FED does not have to be as aggressive with raising interest rates.  In fact, if they are too aggressive tight money will choke the expansion that took almost ten years to finally arrive.

President Trump is right again, the FED should forgo a rate increase in December.

Michael Busler

Michael Busler, Ph.D. is a public policy analyst and a Professor of Finance at Stockton University where he teaches undergraduate and graduate courses in Finance and Economics. He has written Op-ed columns in major newspapers for more than 35 years.