Is the Fed under the spell of a ‘money illusion’?

Magician's hands above and below floating dollar bills
Photograph by Martin Rogers — Getty Images

On Friday, the Labor Department will release its monthly employment report, which will include an estimate of the number of jobs the U.S. economy added in February.

But many market watchers will be paying closer attention to how quickly the report estimates wages have risen, rather than the headline jobs figure. This is because we have already reached a point where job growth is faster than at any point since the late 1990s; for the economy to really gain steam, all that’s needed now is for workers to start to see their wages rise faster.

Slow wage growth has dominated the national conversation to the point that it was even a primary theme of the president’s State of the Union Address in January.

But according to James Paulsen, chief investment strategist and economist at Wells Capital Management, our obsession with slow wage growth might be the result of policy makers being under the spell of a “reverse money illusion” brought on by the persistently low inflation the economy is experiencing right now.

Why a reverse money illusion? As Paulsen writes, “in the 1970s, we learned our enthusiasm for pay raises needed to be tempered by the overall rate of inflation. That is, the 1970s culture was educated about ‘money illusion’—confusing nominal wage gains with rising real purchasing power.”

This time around, Paulsen argues, we are suffering from the reverse, where the public isn’t appreciating the gains in purchasing power workers have seen since the end of the financial crisis because inflation has been so low. Here’s a chart from Paulsen showing the real wage rate, or average hourly earnings divided by the consumer price index :


By this measure, wages are higher today than at any time since the 1970s, and the real rate is 5.1% higher today than it was in 2007. In the following chart, Paulsen shows how the U.S. economy is doing by this measure compared to past recoveries:


The current economic recovery stacks up well compared to others since the late 1970s. While the growth in the wage rate doesn’t come close to what we experienced in the 20 years following World War II, the U.S. economy also had advantages during that time that are unlikely to be reproduced any time soon.

Paulsen thinks that the economy and the labor market are actually performing better than we think. He argues that the Federal Reserve is too focused on the lack of nominal wage gains and that it lacks justification for engaging in what he calls “unprecedented, crisis-level” interventions into the market.

Then again, it’s important to remember that the Federal Reserve has two responsibilities: to maintain full employment and to keep prices stable, which the central bank (and mainstream economics) defines as 2% inflation per year. Since we’re not yet at full employment, and since the U.S. has consistently undershot its inflation target for years, there’s plenty of reason to believe that keeping monetary policy loose for the time being makes sense.

Also, since these data describe average hourly earnings, they could be reflecting the rising pay at the very top of the income spectrum. And America has a serious problem with underemployment, in which workers who want to work full-time can’t get 40 hours of work per week. Rising hourly pay doesn’t necessarily help a person when all she can get is part-time work. Also, there is a disconnect between rising productivity and median income; in other words, workers are not getting their fair share of America’s income pie.

But Paulsen’s data show that the labor market is tightening, which suggests that the Fed could very well raise interest rates sooner rather than later. It also shows that while the media has been increasingly focused on statistics of rising pay (or the lack thereof), it hasn’t necessarily done a great job of putting those numbers into historical context.

Americans might not be getting the sort of raises they think they deserve, but this is not a unique phenomenon.

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