Friday’s employment report was generally strong, with job growth of 211,000, declining unemployment and a drop in the number of workers involuntarily confined to part-time work.
These data, along with indications that growth in the second quarter is likely to come in above 3 percent, suggest the economy is reasonably robust. But they present difficult issues of interpretation and policy choice for the Federal Reserve. Is the economy or the stock market enjoying a “sugar high,” or is the current path sustainable? What weight should the Fed give strong employment figures relative to gross domestic product growth that remains modest by historical standards and relative to low rates of inflation and expected inflation? How should the Fed treat the tension between the great uncertainty that so many economic actors experience and near-record-low levels of market volatility and expected volatility?
Given how little the administration has actually changed policy, recent economic performance was pre-determined before Donald Trump took office. Stock markets have boomed in recent months, but it is less obvious that there is a sugar-high element in their performance than seemed to be the case around the turn of the year. Fundamentals unrelated to the new administration have strengthened, particularly as strong earnings reports for the first quarter have come in, growth abroad has strengthened and bond yields have declined. At the same time, the “Trump signature” in the market has attenuated: For example, high-tax stocks that outperformed after the election have given back their outperformance.
The greatest puzzle regarding the stock market is not its level but its remarkable lack of volatility. We have for months been in a period where volatility has been low by historic standards, despite what seems high policy uncertainty. Perhaps this reflects technical factors in the market. It may also be that uncertainty is a kind of self-denying prophecy as it causes investors to scale back their leverage, which in turn limits volatility. It is probably important to recognize also that much of market volatility reflects factors other than economic policy. It is now very difficult to argue that there is a large amount of slack in U.S. labor markets. Another year of employment performance like we have seen during the past few months would take the labor market into nearly uncharted territory. It has been surprising, in the face of this labor market tightening, that there has not been more evidence of accelerating wage inflation. A reasonable conjecture is that this reflects workers cowed by the possibility of being replaced by technology or foreigners. Indeed, given the tightness of the labor market, workers appear relatively reluctant to quit jobs.
What about slow GDP growth? There is little reason to think that growth has moved out of the 2 percent range in which it has been stuck for the past half-dozen years. If, as seems arithmetically almost inevitable, employment growth slows, GDP growth will, as a matter of logic, slow as well, unless productivity growth accelerates. And there is little in the data to suggest this is likely in the near term.
So the next couple of years are likely to see slower GDP growth and possibly a tendency to rising inflation. What does this mean for monetary policy? The assumption manifest in the statements of the Fed and most commentary is that policy should be tightened over time through rising interest rates and a reversal of quantitative easing. Perhaps, but tightening involves real dangers and needs to be carried out with great care. The Fed has committed itself to a symmetric 2 percent inflation target, and inflation has been below 2 percent for eight years. If a booming economy in the ninth year of recovery with such as prelude is not the time for inflation above 2 percent, when would such a time arise?
Moreover, economists should now have great humility regarding the inflation process. The Phillips curve relation on which they have relied has largely broken down over the past several decades, so relying on it to justify taking preemptive action with respect to inflation seems problematic. It may be that the economy will surprise in its ability to run hot without accelerating inflation. The unemployment rate for college graduates is 2.4 percent, and there is little evidence that their wage growth is accelerating. There is also the observation that price inflation remains very much under control and that some wage growth in excess of price growth would be desirable given the recent erosion of labor’s position in the economy. The Fed will have little room to respond if it overdoes things and the economy goes into recession. Sometimes the hardest and most important decisions in government involve doing less rather than more. This is one of those times for the Fed.