The Federal Reserve held short-term interest rates steady as traders expected. In the Fed’s postmeeting policy statement, it said it only needed “some further evidence” of economic progress before moving forward with a rate hike.
What exactly is the further evidence that the Fed needs? To answer that, you have to know about what happened last year to the unemployment rate and wages.
After the Fed had raised rates in December of 2015, it said that it would raise rates four times in 2016. I went off the rails. Long time viewers of the weekly Saturday night show remember how angry I was at the absurd proposition that the economy was strong enough to hike rates four times in 2016.
The Fed was ultimately wrong in their four hikes in 2016 statement. What happened? Here’s where the Fed went wrong. The Fed thought that in December of 2015 that wages would begin to accelerate rapidly. For most of 2016, the monthly Employment Situation report showed an average of 220,000 jobs added per month. The unemployment rate had gone to 5% from 5.8%. The Fed thought that the demand for labor would shift to the right as illustrated in this graph.
The Fed thought that the demand curve would shift to the right from D to D1. As demand for employment increased, unemployment would continue to fall, and wages would rise rapidly. The problem is that the Fed assumed that the job market was very tight because of the low unemployment rate. In other words, the Fed assumed that the labor market supply was fairly static so that increased demand for labor would cause wages to rise rapidly.
Last year I was one of many voices yelling out to anyone who would listen that the labor force participation rate was dropping.
What this means is that the supply of labor was not static at all, in fact, it was just the opposite. The labor market continued to generate jobs at an average of 187,000 per month for most of 2016, but the unemployment rate stayed at 5%, and wages barely moved at all. Why? Because, as the labor participation rate was signaling, people came off the sidelines and back into the job market. We know this because the labor participation rate began rising in 2016.
As you remember from our lesson on illegal immigration, a rise in the supply of labor shifts the supply curve down. In other words, it largely offsets the outward shift of the demand curve! In case you don’t understand, let’s track this on a supply and demand graph.
In step 1, the labor demand curve shifts outward from D to D1 as the Fed predicted. A new equilibrium is established at point a. In step 2, suddenly people who gave up looking for work see wages rising, and so they come back into the labor market looking for work. That increase in labor supply shifts the supply curve down from S to S1 as wages fall. A new equilibrium is established at point b, the same original wage rate! We have a greater number of people employed, but the unemployment rate and more importantly wages stay the same.
At the end of 2015, the Fed thought the labor rate was much tighter than it really was because of the low unemployment rate. There was a lot more slack in the labor market (low labor participation rate) that was not being factored into the Fed’s equations. In other words, the Fed made a mistake by miscalculating how many people were on the sidelines and ready to jump back into the job market at the first sign of rising wages. That’s why the Fed said in December of 2015, after hiking rates a quarter point, that they would likely be hiking another four times in 2016. They thought wages were going to move higher really fast. There was much more slack in the labor market than the Fed thought, and there could still be more.
The Fed got fooled once. The Fed will not get fooled twice. This is what I think the Fed means by it only needs “some further evidence” of economic progress before moving forward with a rate hike. The Fed wants a little more evidence before hiking rates that most of the slack in the labor market is gone and that wages are rising from an outward shift in the labor demand curve.