Yellen Rate Hike Speech: A Light At The End Of The Tunnel For Wages?

U.S. stocks perked up Friday, a day after Federal Reserve Board Chair Janet Yellen said in a speech that an interest rate hike is still likely in 2015. But buried in her 40-page speech were notes that could perk up ordinary wage-earners as well.

Yellen’s overall message hasn't changed significantly since she announced more than a week ago that the Fed would hold off on a rate increase: “Prospects for the U.S. economy generally appear solid,” Yellen said Thursday. But the takeaway for ordinary wage-earning Americans was considerably more nuanced, reflecting the tenuous state of the recovery for working America.

In her talk Thursday, a prolonged lecture on inflation rate theory at the University of Massachusetts, Amherst, Yellen emphasized that the lagging inflation rate of the past several years was due for a pickup. Economists watch for slight rises in inflation as signals that economic engines are running too hot.

Indeed, economic data have been mostly positive. Employers added more than 210,000 jobs a month this year and the headline unemployment rate is at a respectable 5.1 percent. According to the latest revisions, gross domestic product grew at a healthy 3.9 percent in the second quarter.

But core inflation, excluding volatile food and energy prices, is about 1.5 percent below the Fed’s 2 percent target. The continued sluggishness, Yellen said, owed primarily to the dollar’s 15 percent appreciation in the last year combined with low energy prices.

The picture is further complicated by a relative lack of wage gains since the recovery began. Wages tend to pick up when the labor market is full and employers have to compete for new hires. But since 2010, wage gains have come in well below the 3.5 percent year-to-year growth that economists see in line with rising inflation.

Yellen has said that the conundrum of anemic wage growth derives in part from remaining slack in the labor market; though headline unemployment rates have come down to healthy levels, the “real” unemployment rate -- including reluctant part-timers and those who have given up on finding a job -- stands at over 10 percent.

But on Thursday Yellen elaborated how the Fed sees wages tying in with the broader economy. She dismissed the effect wage gains have on inflation, arguing that one no longer necessarily followed the other.

“In the past, wages provided a good empirical indicator of the future direction of price inflation,” Yellen explained in a footnote. As employers responded to pressures to pay workers more, companies would respond by increasing prices.

But that era in the American economy is over. “The wage-price spiral no longer seems to provide a useful description of the U.S. inflation process,” Yellen said.

For those looking into the economic tea leaves for an indication of when wages will start to rise, Yellen’s message is: patience. According to her model, inflation will likely arrive sometime in 2016 -- before any accelerated wage growth. By that time, it’s likely the Fed will have raised rates.

So why is inflation so low? Low energy prices and a strong dollar have helped keep consumer goods and imports cheap, Yellen said. The impact that slack in the labor market might have, according to her model, has diminished to a sliver. The green box in the chart below shows the negative impact that labor market slack has on inflation -- easily outdone by the effect of moves in oil and the greenback.

Why Has Inflation Fallen Below 2 Percent?

Many economists consider 5 percent to be near the threshold of the natural rate of unemployment, at which point inflation starts to rise. But Yellen included a telling caveat in her prepared remarks: “The current difference between the unemployment rate and its normal longer-run level likely understates the actual amount of slack that remains in the labor market,” she said, estimating that if the unemployment floor did not coincide with Fed predictions, slack might play a larger role in the inflation picture.