So, what happens if the unemployment rate falls to 3.6 or 3.7%? I think it’s a question worth asking because of the above-consensus private payroll report from ADP today. It showed 235,000 jobs added to private payrolls, well above the 203,000 expected. If we continue to add even 150 or 200,000 job a month to payrolls, unemployment could dip into the mid 3% level by the end of the year. And then we have to ask what does the Fed do.

Here are some thoughts.

The red-hot overheating economy

First, notice what Mark Zandi, chief economist of Moody’s Analytics, is saying. “The job market is red hot and threatens to overheat. With government spending increases and tax cuts, growth is set to accelerate.” We’re at an unemployment rate of 4.1% right now. And Zandi is saying the economy is on fire. That’s economist speak for overheating aka a sign that the Fed needs to get a move on.

Now, if you listened to Federal Reserve Chairman Jerome Powell last week in his testimony before Congress, his views seem to dovetail with Zandi’s. Powell talked of the Fed striking “a balance between avoiding an overheated economy and bringing PCE price inflation to 2 percent on a sustained basis.” That word overheating is the key one. It tells you he has a bias toward raising interest rates.

The not red-hot economy

But what if Zandi and Powell are wrong? What if the economy’s not red-hot? For example, Business Insider’s Pedro da Costa noticed a several days ago that about a quarter of jobs in the US are low wage jobs. That’s a figure directly from the Fed’s own Community Advisory Council.

This datapoint on low-wage jobs suggests that a lot of the new jobs are lower-paying jobs. And Pedro reminds us that a sharp drop in hours worked accompanied the rise in hourly earnings in January that sparked a market selloff. He quotes Komal Sri-Kumar, president of the economic consulting firm Sri-Kumar Global Strategies, saying “the number of hours went down so much workers had less to spend. I have a hard time understanding how that is supposed to be inflationary.”

Moreover, immediately after the last jobs numbers came out. I pointed out that non-supervisory wagees were not rising as fast as the headline figures. And, in fact, the rise in average hourly earnings trails both the 1990s and the 2000s.

Look at the numbers Dartmouth Economist Danny Blanchflower came up with:

I am sceptical about this thesis that the US economy is red hot.

The inflation model is wrong

And the way we have been discussing wages is all wrong anyway.

Economists talk about “low, low unemployment” like we have now as a bad thing. They act as if it is a precursor to inflation that the Fed needs to correct. In that framing, 4.1% unemployment is too low. And, so the thinking goes, the Fed needs to raise interest rates to make sure inflation stays low.

But recent research from McKinsey says increasing wages are key to economic growth. I think that’s an important point regarding causation. People like former Fed Chair Alan Greenspan have been telling us higher wages are a threat because of low productivity. The higher wages and low productivity lead to inflation that the Fed needs to stop. But McKinsey is saying higher wages cause higher productivity growth, investment and economic growth. And investment and productivity growth are the things that help the economy grow without inflation rising.

It is altogether possible that we’ve got it backwards. Higher wages lead to consumption of higher value-added products, greater goods and service complexity, higher investment and greater productivity growth. All of that puts a check on inflation rather than causing it.

The Fed will make the call about overheating

It doesn’t mater though. What matters is what the Fed does. And if Powell’s recent commentary is indicative of the thinking, we should expect to see higher rates. New York Fed President Bill Dudley even said that raising interest rates four times this year would be accommodative. The Fed has been saying it would raise rates three times. So Dudley is making the argument that the Fed could become more aggressive still and that wouldn’t be too aggressive.

Dudley makes a valid point. After all, under Alan Greenspan the Fed raised US rates a quarter percentage point at every meeting. Now we aren’t even doing it at every other meeting. That’s less than half as fast.

However, my point in this post is to provide a basis for questioning the narrative underlying the Fed’s policy. Despite the historically low headline rate of unemployment, the employment outlook is not threatening.

  1. Worker pay is not rising as briskly as the Fed believes.
  2. Even if wages did rise more briskly, that wouldn’t necessarily be inflationary.
  3. The headline rate of unemployment masks a move to lower-pay jobs and an increase in more unstable gig-economy and part-time employment.

One could make an argument for letting the economy run until it ran hot – and then instituting a regime shift. I believe that’s the argument St. Louis Fed President James Bullard makes.

In my view, the US economy is not red-hot. I don’t fear overheating. But I believe the Fed does. And it will act accordingly.The regime shift is happening now. We’ll just have to see how the economy responds.