Is the US ready for normal monetary policy?

Federal Reserve Chair Janet Yellen later this week will testify before Congress about the state of the U.S. economy. Hanging over her testimony will be whether the Federal Open Markets Committee, the arm of the Federal Reserve that sets monetary policy, is ready to raise interest rates later this year. Interest rates have been at zero since late 2008. But has the time arrived to take this major step toward normal monetary policy?

Part of the Federal Reserve’s mission is to promote maximum employment. Amid the current, five-year-long economic recovery, economists have debated the natural rate of unemployment. Basically, what’s the unemployment rate at which inflation becomes untethered and the Fed needs to start reigning in economic growth?

Wage growth has been stalled at around 2 percent for several years now, despite hints and hopes of acceleration. The latest data from 2014 shows that low-wage earners saw their wages increase, despite declines for other workers. So the question is this—what will spark stronger wage growth?

The answer, in short, is tighter labor markets. As more workers get jobs, wage growth should accelerate. Another way to look at this question is to see how wage growth changes at the employment rate moves around.

Earlier this month, Equitable Growth’s Ben Zipperer looked at that very relationship. If we assume long-run productivity growth is about 1.5 percent and inflation is 2 percent, in line with the Fed’s target, then average wage growth should be at least 3.5 percent a year.

So when does wage growth cross above this threshold? According to the data Zipperer looked at, not until the employment rate for workers ages 25 to 54 crosses 79 percent. (See Figure 1.)

Figure 1

As of January 2015, this prime-age employment to population ratio was 77.2 percent. The ratio has been on the rise, but it still has a ways to go before it hits 79 percent. Growing at its current rate, that rate won’t hit 79 percent until 2017 at the earliest.

The U.S. labor market is growing stronger, but that is not a sign of a finished job. With inflation below its target, worries about stalled or slowing economic growth abroad, a strengthening dollar, and an incomplete labor market recovery, the Federal Open Markets Committee should consider the consequences of raising interest rates too soon.

Perhaps the best move is to do nothing and simply wait. Normalcy, it appears, has not returned quite yet.

This article is published in collaboration with The Washington Center for Equitable Growth Publication does not imply endorsement of views by the World Economic Forum.

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Author: Nick Bunker is a Policy Research Associate with the Washington Center for Equitable Growth.

Image: Morning commuters are seen outside the New York Stock Exchange, July 30, 2012. REUTERS/Brendan McDermid.