Evidence that tight labor markets really will increase labor’s share of income: Economic Policy Institute Macroeconomics Newsletter

That newsletter wasn’t the first time I’ve stressed that the Fed should allow ever-tighter labor markets until the labor share of income normalizes or until there is an extended period of above-target price inflation. The argument, put simply, is this: If price inflation accelerates well before the clawback of labor’s share of income, this would be some evidence that structural changes (perhaps growing industrial concentration of product markets) have contributed to the fall in labor’s share, and that tighter labor markets by themselves will not be enough to return this measure to pre–Great Recession levels. However, if we don’t see this outbreak of extended above-trend price inflation well before any clawback, it means the Fed can and should strive to restore labor’s share by keeping labor markets tight.

In today’s newsletter, I follow up on those arguments, looking specifically at whether there really is a reliable positive effect of tight labor markets on labor income shares. If there is such a reliable effect, this provides a strong argument that the Fed should keep labor markets tight until labor’s share moves much closer to its pre-recession levels.

This analysis yields three key conclusions:

• Recent years have seen the relationship between low unemployment and faster price inflation greatly attenuated. Put simply, in the last decade tighter labor markets have seemed less and less likely to lead to rapid price acceleration. This means the risk to the Fed’s inflation mandate from allowing tight labor markets has substantially declined.

• There is indeed a reliable effect of sustained tight labor markets leading to increases in labor’s share of income. This finding convincingly shows that the conventional wisdom characterizing the labor share of income as simply “countercyclical” is far too simple and masks important dynamics of the labor share over business cycles.

• For each year that today’s state of labor market tightness persists, we should see a nearly 1.5 percentage-point increase in labor’s share of income. As of the fourth quarter of 2018, the U.S. labor share of income was roughly 4 percentage points below its pre–Great Recession peak. This means that we would need to maintain today’s state of labor market tightness for more than two years to see a return to pre-recession labor share.

Let’s go into a bit more detail on each of these points.

How do we know we’re at less risk of rapid price acceleration from sustained tight labor markets?

Traditionally, the primary argument against allowing “high-pressure” labor markets to persist for a sustained period was that this risked an outbreak of price inflation well above the Fed’s target. The fear was that even a brief spell of above-target inflation could set off a wage–price spiral that would require large interest rate hikes to quell, and that these rate hikes would substantially slow growth or even put us into a recession.

New analysis from Jared Bernstein of the Center on Budget and Policy Priorities demonstrates that the relationship between unemployment and price inflation has greatly attenuated in recent decades. Figure B adapts a figure from Bernstein’s forthcoming report showing a rolling regression of price inflation predicted by the “unemployment gap”—the difference between the actual unemployment rate and the Congressional Budget Office’s (CBO’s) 2010 estimate of the natural rate of unemployment.

A rolling regression is an analysis of the changes in the statistical relationship between variables over time. In this case, the regression’s dependent variable is price inflation, and it is being correlated with the unemployment gap. The entire data set includes quarterly data from 1959 to 2018. But for the rolling regression, instead of using the entire data set to estimate the relationship between the unemployment gap and inflation, the regression is instead first estimated over just the first 80 quarters of data. The regression coefficient representing the correlation between the unemployment gap and inflation is then plotted. Then the first observation is dropped and replaced with the 81st quarter of data, and then the first observation of this new data set is dropped and replaced with the 82nd quarter of data, and so on. Each subsequent regression provides a new measure of the correlation between the two variables, and each subsequent regression uses more recent data than the last.

The striking finding evident in Figure B is that correlation between the unemployment gap and price inflation (the middle line) steadily weakens over time, becoming economically and statistically insignificant in recent years. In the graph, this is seen as the middle (green) line plotting the regression coefficient in successive years rapidly approaching zero since the mid-1990s.