The Cleveland Fed’s Puzzle on Future Economic Activity

By Pam Martens and Russ Martens: August 28, 2014

Edward S. Knotek II of the Cleveland Fed

Edward S. Knotek II of the Cleveland Fed

Edward S. Knotek II and Saeed Zaman work for the Federal Reserve Bank of Cleveland. On August 19 they posted a paper at the Cleveland Fed’s web site that looked at causal relationships between wages, prices and future economic activity.

Knotek and Zaman have two Ph.D.s between them. Their paper arrives at this conclusion:

“…subdued wage growth is symptomatic of the existence of slack in the labor market. But given wages’ limited forecasting power, they are but one piece in a larger puzzle about where the economy and inflation are going.”

What Knotek and Zaman are pumping out as forecasting research at the Cleveland Fed is important because the President of the Cleveland Fed, Loretta J. Mester, is a voting member of the Federal Open Market Committee (FOMC) that sets monetary policy for the U.S. central bank. Mester will help decide when interest rates are hiked to help thwart future inflation.

If rates are hiked prematurely, the country could end up in the safety-net-enhanced version of the Great Depression (indeed, we already may be in just that) or in a Japan-esque multi-decade effort to climb out of the quicksand hell of deflation.

Saeed Zaman of the Cleveland Fed

Saeed Zaman of the Cleveland Fed

What Knotek and Zaman have done here is to make an omelet and forget the eggs. One can’t have a cogent discussion today about where the economy is going without including the perhaps uncomfortable but essential ingredient – unprecedented wealth and income inequality.

Here’s an alternative analysis that includes the eggs:

Yes, there is slack in the labor market. Yes, that induces fear among workers who resist asking for wage increases. The fact one’s neighbor lost his job and has been unemployed for more than a year adds to that fear. The fact that the bright college graduate down the block is working as a waiter also adds to that fear. The reality that unions can’t negotiate for higher wages across a broad swath of the labor force because their ranks have been decimated to just 6.7 percent of private sector workers adds further to the downward bias on wages.

Take a frightened workforce and add to that the disappeared workers – the labor force participation rate stood at a meager 62.9 percent in July – and one begins to see why inflation has been running at an annualized rate of less than 2 percent this year. (To broaden the record, interest rates were negative for nine months out of twelve in 2009, the first year after the Wall Street crash – looking eerily similar to the onset of a depression. A panicked Fed secretly pumped a collective total of  $16 trillion in below market-rate loans to the Wall Street banks that created the crisis as well as foreign banks over the crisis years of 2007 through 2010 in hopes of averting a Great Depression style deflation.)

The U.S. worker is also a consumer and with tepid wage gains and lack of heft in disposable personal income it is incontrovertible that there will be tepid consumption. Since consumption represents 70 percent of U.S. GDP, we don’t believe there’s any puzzle at all about where this economy is going.

Just this month, the Fed’s own scholars found that 52 percent of Americans would not be able to raise $400 in an emergency by tapping their checking, savings or borrowing on a credit card, which they would be able to pay off when the next statement arrived.

Equally alarming, with a $17.7 trillion national debt and the Fed tapped out with a $4.3 trillion balance sheet, just where is the stimulus going to come from to jolt this economy out of the next leg of the downturn.

We also don’t think there’s any puzzle at all about where the economic problems arise in the U.S. It’s the income inequality – period. No Phillips’ curves and cross-correlations are needed to figure this out.

Think Progress posted a clear, jargon-free report on the problem just yesterday. Citing data from a new paper by Elise Gould at the Economic Policy Institute, author Bryce Covert notes that productivity grew by approximately 65 percent between 1979 and 2013, but hourly compensation for workers, not including supervisors and managers, grew by just 8 percent.

Covert writes: “The top 1 percent, on the other hand, got a 154 percent raise in wages over the same time period, far more than the growth in productivity and more than four times more than average wage growth.”

An updated study released last year by noted economists Emmanuel Saez and Thomas Piketty found that in 2012 the top 10 percent of wage earners took home more than half of the nation’s total income – the largest share since the government began collecting the data a century ago – while the top 1 percent accounted for more than 20 percent.

If the Cleveland Fed or any other regional Fed Bank is serious about researching future economic activity, it will add income and wealth inequality to the mix.

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