Income Inequality and Fed Policy

“The extent of and continuing increase in inequality in the United States greatly concern me ... It is no secret that the past few decades of widening inequality can be summed up as significant income and wealth gains for those at the very top and stagnant living standards for the majority. I think it is appropriate to ask whether this trend is compatible with values rooted in our nation's history, among them the high value Americans have traditionally placed on equality of opportunity.”

– Janet Yellen, October 17

Income inequality has been an important topic this year, but it is one that is mired in politics. That means it is a potentially treacherous debate for the Federal Reserve chair to wade into. To be fair, Yellen said that the purpose of her recent talk on income inequality and opportunity was “not to provide answers to these contentious questions, but rather to provide a factual basis for further discussion.” She provided a mountain of evidence from the Fed’s triennial Survey of Consumer Finances, and then got out of the way, as appropriate.

However, what she didn’t say was even more important. Income inequality has begun to play a larger role in the economic outlook and will likely be increasingly incorporated (albeit indirectly) into the Fed policy outlook. Before she became Fed chair, Yellen was known to place considerable weight on the labor market. This emphasis has only increased since she took the helm. That does not mean that she is willing to sacrifice the Fed’s commitment to low inflation. It does mean that she will pay greater attention to the interactions between the job market and inflation in setting monetary policy.

While many short-term gauges of the job market (weekly jobless claims, the percentage pf people unemployed for a half a year or less) are trending at levels that one would normally associate with an economy that has fully hit its stride, other measures continue to suggest that an ample amount of slack remains. Views regarding how much slack are the key difference among policy monetary policy makers.

One of the key indicators of slack is the lack of real wage growth. Job growth is a key element of economic growth. However, average wages have struggled to keep pace with inflation, which means that most of the gains in consumer spending have come from added jobs rather than improvement in average wages (although wealth and borrowing have some impact on spending). The lackluster trend in average wages has also been a factor in income inequality. The share of national income going to profits is up; the share going toward labor compensation is down. Theoretically, this should take care of itself as the economy improves and the labor market tightens, but we may not see that happen for some time.

In its large scale model of the economy, the Federal Reserve sees inflation as a function of inflation expectations, the slack in the job market, and oil prices. Inflation expectations are a measure of inertia and market indicators suggest that they remain well-anchored. Oil is different from other commodities. Oil price increases show up quickly at the pump (declines show through more slowly). Goods have to be shipped. Offices have to be heated or cooled. However, the slack in the job market is seen as the more significant factor. The labor market is the widest channel for inflation pressure. As the job market tightens, wages should be bid up at a faster pace and firms ought to be able to pass some of that added cost along. However, the Fed’s economic model is only one factor in setting monetary policy. Officials will incorporate a lot more judgment.

The recent decline in oil and gasoline prices should factor into the Fed’s policy decisions, but it’s unclear how much and in what direction. Lower gasoline prices will add to consumer purchasing power, but it depends on the magnitude of the decline and how long prices stay low. There may be a small benefit to the consumer during the important holiday shopping season, but we’re likely to see a bigger impact in the early part of 2015 (provided gasoline prices continue to fall). Since consumer spending accounts for 70% of the economy, lower oil prices ought to help boost GDP growth in early 2015 and job growth should be higher than it would be otherwise. Hence, more labor market slack will be taken up.

On the other hand, lower oil and gasoline prices will put downward pressure on consumer price inflation, which has already been trending below the Fed’s comfort range. It is real (that is, inflation-adjusted) interest rates that matter. So, all else equal, lower inflation implies higher real interest rates. The lower inflation outlook should delay the timing of the Fed’s initial increase in short-term interest rates.

Yellen and other senior Fed officials have indicated that they are willing to tolerate some pickup in average wages. However, any meaningful increase in average wages is not expected until the labor market tightens a lot more. Clearly, there are many uncertainties ahead. Fed policy will depend on how the economic outlook evolves over the next several months.

After introducing the Fed’s data on income inequality, Chair Yellen was right to step away from the discussion. However, she did address something that just about everyone can agree with – that is, that all Americans should have the opportunity to succeed. One major concern is that the increased level of income inequality is contributing to a decrease in opportunity. Yellen cited support for early childhood education, access to higher education, and greater business formation as important “building blocks” for economic opportunity.

© Raymond James

© Raymond James

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