And considering that this $ trillion represents perhaps as little as one-fifth of the amount of ready liquidity in the U.S. financial system – that being held not just on deposit at the Fed Banks but also by nonfinancial corporations, private equity funds, other investors and households – there is a lot of inflationary tinder available should the Fed mismanage its exit from the hyper-accommodative policy we have pursued and augmented with QE3. Thus, only time will reveal the efficacy of the policy we have pursued and whether the risks that I and other observers (among them my mentor, Paul Volcker) fret over are as substantial, or whether we have made much ado about nothing. My former colleague, the wonderful ex-banker and much-admired Fed Governor Betsy Duke, was quoted on Oct. 28 in The Washington Post as saying this about QE3: “It’s still important to see what the ultimate costs are going to be. You can’t really judge those until it’s completely unwound.” 4 Betsy is spot on. Channeling Shakespeare In June of last year, I gave a speech in Toronto in which I likened the post-zero-bound monetary policy to a Shakespearean drama with five acts, suggesting we were then in the last scene of the third act of a play titled “The Grand Experiment in Modern Monetarism.” 5 I posited we will not know until the final act whether the play will end felicitously or otherwise. I thought I would update that analogy here today.
Since then, the unemployment rate has fallen by a little less than 1 percentage point each year, and wage growth has picked up by 0.2 percentage points each year. Three quarters into 2014, wage growth is already up another two-tenths, to 2.1 percent at an annual rate. This pattern of rising wage growth is roughly what one would have expected judging by prerecession data. 3 If anything, wage growth has been running a bit above what we should have expected. This contradicts the view that the unemployment rate has understated labormarket slack. Of course, the Federal Reserve has a target for price inflation, not wage inflation. The rate of wage inflation consistent with our 2 percent price-inflation target depends on secular trends in labor productivity growth and in labor’s bargaining power – trends over which the Federal Reserve has no control and about which it can only make informed guesses. Nevertheless, the Dallas Fed’s study of the Phillips curve has an important lesson for Fed policymakers: If we keep pushing on the accelerator pedal until wage growth matches the rate that we believe to be sustainable, we will likely have pushed too far and missed our exit. Because wage growth reacts to slack with a lag, it will continue to increase even after policy stimulus is removed. Because wage growth rises at an increasing rate the farther the unemployment rate declines, the overshoot is likely to be large. I liken monetary policy to duck hunting.