Many people are aware of the Federal Reserve’s pending decision on interest rates expected later this week. For the first time in 9 years, the Fed is expected to commence with a small, gradual increase in the federal funds target rate. While much speculation has swirled around the ramifications of an increase, one aspect that has been overlooked, however, is the huge impact these decisions will have on workers’ paychecks.
The basic story is that there has been a huge redistribution from wages to profits associated with the Great Recession. Workers had gotten more than 80% of the income generated in the corporate sector for most of the five decades before the start of the Great Recession. The high unemployment at the start of the recession weakened workers bargaining power. As a result, the share of income going to wages and benefits fell as low as 73%. In the last couple of years the labor share has inched up slightly as the labor market has improved, but it is still below 75%.
This is where the Fed enters the picture. While the unemployment rate is getting close to pre-recession levels, the employment to population ratio (EPOP), the percentage of the workforce with jobs, is still well below its pre-recession level. This is true even if we just look at the prime age workforce (ages 25-54) – those people old enough to likely be in the workforce and those who have not yet retired — to avoid the distortions caused by the retirement of baby boomers.
The EPOP among prime age workers is still down by almost three full percentage points from its pre-recession level and four percentage points from the peaks hit in 2000. Other measures of labor market slack, like the quit rate and the number of people involuntarily working part-time jobs, also indicate a labor market that is far from full employment.
This matters for wages because if the labor market is allowed to tighten further, workers will likely be able to regain much or all of the wage-share they lost in the Great Recession. While many economists have developed theories that attribute the drop in wage shares to changes in technology, globalization, or other factors, this is all ad hoc theorizing.
No one was predicting that a sharp drop in wage shares was imminent in 2007 before the crash. And, there is little reason to believe that the economists now coming up with these explanations for the drop in the wage share have any better understanding of the economy today than they did in 2007. In other words, there is little reason for us to take these explanations seriously. The bargaining power explanation due to the rise in unemployment is the simplest and most obvious explanation for the plunge in the wage share.
In this case, if the Fed were to decide to allow the labor market to tighten and workers to gain bargaining power, we would see an increase in the labor share, presumably getting back to pre-recession levels. The more rapid wage growth would mean somewhat higher inflation, but since the inflation rate has been extraordinarily low for the last six years, a modest uptick in the rate of inflation would be desirable.
In fact even the Fed should welcome higher inflation since it has been running well below its 2.0% target for the last six years. And, since this 2.0% is an average rather than a ceiling, the Fed should want to maintain an inflation rate somewhat above 2.0% for a period of time.
On the other hand, if the Fed raises interest rates enough to prevent the wage share from rising, it will mean a massive hit to workers’ wages. If we assume the wage share should be 80.0% and Fed policy keeps the wage share at its current 74.5%, the Fed has effectively imposed a 6.9% tax on wages.
If that doesn’t sound like a big deal, imagine if one of the candidates running for president proposed a payroll tax hike of 6.9 percentage points. In fact, the situation is likely even worse for workers at the middle and bottom of the wage distribution, since high unemployment takes more of a bite out of the wages of assembly line workers and retail clerks than doctors and lawyers.
Workers should be very focused on Fed policy in the near future. It is likely to have far more impact on their living standards than the various tax schemes that the presidential candidates tout over the next year.
Dean Baker is a macroeconomist and co-director of the Center for Economic and Policy Research in Washington, DC.