CWP=D: Part II - Wages and the Fed's Reaction

In Part I of the EconomPic "series" CWP=D (consumption without production equals debt) we took a look at one of the earlier factors that played a role in the high debt and unemployment levels we have today; namely the huge labor supply shock from emerging markets.

In Part II, we'll take a look at the impact of that labor supply shock on the price and quantity of U.S. labor and more importantly, the reaction by the Federal Reserve to that impact.

Part II: Impact of Supply Shock on U.S. Labor

Incremental cheap foreign labor should have:

• Been disinflationary (or deflationary) for labor and goods that used that labor as an input
  
• Caused NAIRU (the natural rate of unemployment) to rise

What Happened?

Well, it took a bit of time (more on that at a later date), but real wages (shown below as personal income less the amount transferred by the government) fell and NAIRU (if the employment to population ratio shown below is a good indicator - I think it is) rose (i.e. employment fell).

Personal Income

Employment-Population Ratio

If you earn less, you should in theory "have" to consume less, but the Federal Reserve having missed the fact that there was a labor supply shock overseas (causing jobs to leave the U.S.), provided a big boost that allowed consumers to spend without earning (i.e. they lowered rates in an attempt to stimulate hiring through an increase in the economy's aggregate demand).

This response is shown in the chart below which details the Fed Funds rate less the 12 month headline CPI going back to the 1960's. Real rates over the past 10 years have now averaged a negative level for the first time since inflation drove real rates negative in the 1970's.

In the past, increased consumption would have flowed through to the supply side of the U.S. economy, pushing corporations to hire U.S. labor to keep pace. This time, a large amount of the increased consumption leaked out of the U.S., which explains why we had a "jobless recovery". This helped mask the initial misallocation of capital as the rising cost of shelter and commodities were offset by "imported deflation" in the form of cheap goods utilizing the cheap labor from abroad.

To be continued...

Source: BEA, BLS, Federal Reserve