The great experimentWhat will result from America’s strangely timed fiscal stimulus?

GOOD economic news is not always good for everyone. On February 2nd it was revealed that average hourly wages grew by 2.9% in the year to January—the fastest growth since 2009, at the end of the recession. Stocks promptly tumbled around the world (see article). Investors fretted that inflation might rise, forcing the Federal Reserve to raise interest rates further and faster than expected. Whether the jitters are justified, however, depends on how an extraordinary experiment in economic policy plays out. America is poised to stimulate an economy that is already growing strongly, at a time of historically low unemployment.

Most of the stimulus will come from tax cuts that President Donald Trump signed into law in December. These are worth 0.7% of projected GDP in 2018 and 1.5% of GDP in 2019. On February 7th Senate leaders sketched out a budget deal containing a further fiscal boost. If the proposal passes, defence spending will rise by $80bn this year, pleasing Republicans. Democrats have been offered $63bn in spending on other programmes. The total increase in outlays is worth another 0.7% of GDP. The White House also promises to unveil an infrastructure investment plan on February 12th. Higher spending will add to government borrowing that, after tax cuts, is already likely to reach almost $1trn, or 5% of GDP, by 2019 (see chart 1).

The economy does not look in obvious need of stimulus. Unemployment stands at just 4.1%. Workers are in a seller’s market. Wages are rising and in December 3.3m Americans quit their jobs for pastures new, the second highest reading on record. In 2017 the economy grew by 2.5%, above the roughly 2% trend that official forecasters think is sustainable as the population ages. With the economy so strong, and stimulus on the way, it is natural to worry about overheating. That a new and untested Fed chairman, Jerome Powell, took office on February 5th, as markets tumbled, only makes people more anxious.

Hawks point to the late 1960s for signs of what is to come. In early 1966, following a long spell of low inflation, unemployment fell below 4%. President John F. Kennedy’s tax cuts had been signed into law in 1964. His successor, Lyndon Johnson, raised spending to pay for his “Great Society” programmes and the war in Vietnam. The budget deficit rose from 0.2% of GDP in 1965 to 2.7% of GDP in 1968. Inflation rose, too, to over 3% in 1968 and almost 5% in 1969. As the year ended, fiscal and monetary tightening caused a mild recession.

The comparison is hardly perfect, though. America’s economy was very different in the 1960s. Almost a third of workers belonged to trade unions. Around one in four had wage agreements indexing their pay to inflation. Today fewer than 11% of workers are unionised and wage indexation is so rare that it is no longer closely tracked. Meanwhile global competition and discounting by online retailers holds down the prices of goods. Moreover, the labour market was not the source of the truly memorable inflationary episode of the post-war era. That began in 1973, with the first of two surges in the oil price, which sent inflation soaring to 10%.

In some ways today’s experiment looks more like the boom of the late 1990s (see Free Exchange). Alan Greenspan, then chairman of the Federal Reserve, kept monetary policy loose enough to push unemployment down to 3.8% by April 2000. Mr Greenspan had correctly anticipated that computerisation would increase the economy’s productive capacity and let some of the pressure out of the expansion. Inflation stayed comfortably below 2% even as wages soared. The boom eventually came to an end because a bubble in technology stocks popped—and, perhaps, because Mr Greenspan was less alert to recessionary signals than he had been to evidence of technological change.

As the stock markets wobble again, that parallel may seem unnerving. Hawks have insisted for years that loose monetary policy since the financial crisis would create another bubble—one that, they might say, has now begun to deflate. But unlike in the 1990s, no single major asset class is inspiring irrational exuberance. From bonds to buildings, a wide range of assets are expensive. High prices can be justified so long as low interest rates make future flows of income look more valuable.

In theory, fiscal stimulus should force interest rates up, which explains investors’ worries. The Fed’s model predicts that a tax cut worth 1% of GDP will eventually raise rates by 0.4 percentage points. If the central bank tries to keep rates where they were before the stimulus, the theory goes, inflation will get out of hand. But there are three reasons to doubt that, in reality, enough inflation will appear to force the Fed to change course.

The first is the prospect of another productivity surge. Productivity growth has been feeble everywhere since the financial crisis. Yet technological evangelists insist that a second industrial revolution is coming, in which machine learning and artificial intelligence will allow firms to do much more with fewer workers. Whether they are right or not, rising wages should encourage firms to invest more in labour-saving technology. There are signs already that productivity is rebounding. In every quarter of 2017 it was more than 1% higher than a year before, the first such sustained growth since 2010.

The trend seems to be continuing this year. A real-time estimate of annualised GDP growth in the first quarter of 2018 by the Atlanta Fed stands at 4%. If this estimate is even close to correct, it points to strong productivity growth. The alternative explanation is an unusual rise in employment or average hours worked. But job growth has in fact slowed in recent years; in January it was barely above the average for 2016, when the economy grew by just 1.8%. Average hours worked have fallen slightly.

The second reason to expect inflation to remain subdued is the painful legacy of the financial crisis. Economists have long speculated that recessions might damage the supply capacity of the economy. When people are thrown out of work for months or years, for example, their skills start to atrophy. If so, the thinking goes, strong growth might arrest and even reverse this process—perhaps by encouraging labour-starved firms to offer more training to new staff. That should raise productivity, limiting inflationary pressure. In 2016 Janet Yellen, then chair of the Fed, wondered if the possibility of expanding supply might justify running a “high-pressure economy” once the recovery was complete.

Evidence that recessions damage workers’ skills is patchy. But a related phenomenon may be at work. Because the unemployment rate excludes people who are not seeking jobs, it could be masking potential labour supply. In April 2000 nearly 82% of Americans aged between 25 and 54 had jobs. Today, despite low unemployment, the proportion is 79%. The difference represents about 3.7m potential workers. It is the result of a decline in labour-force participation: many people are neither working nor looking for work.

Get back to work

Official forecasters tend to assume that participation trends are immutable, and do not respond much to economic conditions. But evidence to the contrary is building. In a recent working paper, Danny Yagan of the University of California, Berkeley, compares places where unemployment rose a lot during the recession, such as Phoenix, in Arizona, to those where the increase was less severe, such as San Antonio, in Texas. He finds that for every one percentage-point rise in local unemployment during the recession, working-age people were 0.4 percentage points less likely to be employed in 2015. Unemployment rates in these places have largely converged again, whereas overall employment rates have not, suggesting that some workers were so deterred that they left the labour force altogether. Doves argue that the lower unemployment falls, the greater the chance of bringing such workers back into the fold. Sure enough, since late 2015, as the labour market has tightened, participation among prime-age workers has risen sharply.

The final reason not to fear an inflationary surge is the stability of wage and price growth in recent years. Although markets were spooked by a rise in hourly earnings, perhaps they should not have been. Pay is growing almost exactly as quickly as one would expect from looking at the overall employment rate (see chart 2). Neither wages nor prices are likely to accelerate suddenly, as some economic models forecast, because low inflation expectations have become so firmly rooted. In a recent paper for the Peterson Institute, a think-tank, Olivier Blanchard, who was until 2015 the IMF’s chief economist, concludes that the current relationship between unemployment and inflation is “at odds with the accelerationist hypothesis”.

Higher wages need not mean higher prices. In fact, economists have recently struggled to establish a causal link. Core inflation, excluding volatile food and energy prices, stands at 1.5%, just over half the rate of wage growth. Apart from higher productivity, one way the economy might absorb higher pay is if firms’ profit margins shrink. Over recent decades, corporate profits have risen to record highs as a percentage of GDP. Meanwhile the share of national income flowing to workers has declined. A hot labour market might reverse those trends. Lower profits can be bad for the stockmarket, but they are good for workers. Americans might even become less grumpy about globalisation as the economy heats up. After all, it is less painful to lose a job to trade or technology when vacancies are plentiful.

Poorer households are especially likely to benefit. Between 1996 and 1998 workers at the 10th wage percentile saw their inflation-adjusted pay grow by 9% in real terms, according to one contemporaneous study. That happened despite an increase in the supply of labour. Other research found that young black workers reaped large gains from the hot economy. Similar trends may be playing out now. Since 2016 weekly wage growth has been strongest towards the bottom of the income distribution (see chart 3). Mr Trump likes to boast about recent economic gains for blacks and Hispanics, and in this case he is right.

Continued stimulus at this stage in the economic cycle is hardly riskless. The economy can behave in strange ways when policymakers break norms. And the debt incurred by tax cuts and spending sprees will eventually weigh on growth. But it seems likely that America could keep growing while avoiding an inflationary surge. After decades of weak wage growth, workers may well think the experiment is worth trying.