Yellen on collision course with Wall Street

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17 March 2015 Est. reading: 9 min read

The motivation for the fair wage-effort hypothesis is a simple observation concerning human behaviour: when people do not get what they deserve, they try to get even.
Or put it another way: if people do not get what they think they deserve, they get angry.”

Makes sense doesn’t it? After all, if you think the person beside you is getting paid more than you for the same job, what are you likely to do? You are hardly going to work yourself to the bone. More likely, you will slack. Isn’t it odd that such common sense can sometimes be missing in modern economics? But it is. And in economies where entire swathes of the workforce are working for very low wages, productivity unsurprisingly comes under pressure.

Productivity is the hot topic in the US because the timing and extent of the interest rate hiking cycle will largely be determined by it.

But before we start, who do you think wrote these stirring words on wage motivation?

Surely it must have come from a man of the Left and a well-known agitator for the rights of workers with its vague threat of social unrest? Was it Arthur Scargill, Tony Benn, Ken Livingstone or Ed Miliband? Or even Marx himself?

It was none of the above. They were, in fact, written by the guardian of that cauldron of free-market capitalism, the US banking system. Indirectly, this person has made hedge fund managers spectacularly wealthy and has contributed to making Greenwich Connecticut both the wealthiest, and yet most unequal place, in America.

This homage to the working man is the work of Janet Yellen, US Federal Reserve (Fed) Chair, described by Forbes as the second most powerful woman in the world (the first being Angela Merkel, another who has been partial to a bit of Marxism).

You see, long before Janet Yellen became a central banker, she was an academic who made a significant contribution to our understanding of the US economy.

Through her academic writing, Yellen reveals to us the type of person she is: how her mind works; and how her words shine a light on her politics. Crucially, as we move into the interest rate raising phase of this American expansion, Yellen’s papers are her own personal testimony on the US economy and how it works. Her writings are beautifully straightforward – unencumbered by the Fed’s spin doctors’ neurotic concern for bond traders’ reaction.

Far too often in economics, the personalities behind those who make key decisions are rarely explored. This is particularly the case with unelected, but immensely powerful, central bankers. A politician’s life may be an open book, but the modern central banker – arguably more powerful than the hamstrung politician – remains, bizarrely, a mystery. Little is known about what makes the central banker tick.

Yellen’s roots:

America’s historic labour market battleground

The great battle for American labour was a ground war between Irish Catholic conservative trade unionists and more politically leftist but deeply secular Jewish intellectuals. The Irish trade unionists wanted better conditions for the workingman. In contrast, the Jewish thinkers saw workers’ rights and the emergence of a real leftwing in the US as inextricably linked.

The Irish gave America Tammany Hall and the Democratic Party; the Jews wanted something more European.

The origins of this leftwing thinking came from an East European Jewish secular movement called the Bund, which was popular with Jewish immigrants to the US in the 1920s and 1930s.

In the end, the socially conservative Irish (and Italians) won the battle for the American working class and then proceeded to hound the Jewish intellectuals by creating the Red Scare under the leadership of the Irish senator Joseph McCarthy, where anyone with secular leftist sympathies was immediately labelled a communist and an enemy of America.

McCarthyism destroyed the Left in America and the Irish-dominated post-war Democratic Party, best exemplified by JFK, came to represent mainstream American social democracy – crosier in one hand, pay cheque in the other.

But the defeated Jewish intellectuals didn’t disappear, they merely became less conspicuous while their kids got stuck into education. By the 1960s these children were excelling at university and re-emerged as a huge socially progressive force in the 1960s and early 1970s. They were deeply involved in the civil-rights movement, the anti-war marches and at the forefront of the progressive movements agitating for women’s equality and social tolerance.

Janet Yellen is part of this latter, immensely impressive intellectual force in American society. And this brings us to her academic writing, in which we get a sense of her priorities and her beliefs on how to solve America’s productivity conundrum.

Inside the mind of Janet Yellen

Yellen, together with her Noble prizewinner husband, the renowned economist George Akerloff, is a creature of the American liberal left.

Her writings about the impact of wages on productivity – the most important relationship in the US now as the economy moves towards full capacity – are the type of arguments she will deploy at the upcoming Federal Open Market Committee (FOMC) meetings. These arguments will influence, not just the timing and pace of interest rate hikes in the US but also where rates are likely to ultimately settle.

Janet Yellen is the product of one of the most intriguing intellectual movements in the US – that of left-leaning, Eastern European secular Jewish thinking.

Yellen believes that higher real wages are not only just, but essential if US workers are to become more productive. This suggests that in the long term she believes higher wages enhance individual effort and subsequently increase productivity which, counterintuitively, may be deflationary.

This approach puts her on a collision course with Wall Street’s preferred narrative on wages, inflation and growth.

Unlike her predecessors Volker, Greenspan and Bernanke, Yellen is much more concerned about getting higher real wages on Main Street than higher bond yields on Wall Street. She will not be bullied by bond vigilantes, should they emerge from the low inflationary shadows again.

In contrast to the narrow classical furrow ploughed by so many investment bank economists, Yellen’s writings deploy not just traditional economics but psychology, human behaviour, history and even Biblical references to show how people react to low wages in the real world of the factory floor rather than the gonzo world of the trading floor.

In a seminal paper written in 1990 with her husband, Yellen explores what happens when you don’t pay people well enough.

The Fed Chair’s thinking here is significant because the American economy has recently seen:

  • real wages for the average guy fall sharply over the past decade
  • inequality rising out of all proportion with the top 1% gaining exponentially in comparison to the average worker
  • the return to capital, as opposed to labour, rising every year since the mid 1980s
  • stagnant productivity
  • labour force participation falling relentlessly as people opt out of the workforce

Yellen’s thinking is straightforward. She contends that if people are paid badly they: don’t work hard; are less productive; get jealous; and sometimes simply drop out altogether.

This leads to productivity in the economy in general falling, not rising. Meanwhile, company wage bills rise because workers are working less hard.

Yellen uses the example of Henry Ford, who paid his workers extremely well in order that they might afford to buy the car they were making. As workers’ wages rose, so too did workers’ productivity.

She also quotes the Bible to explain how jealousy affects performance of underpaid workers and she mixes psychology and behavioural economics to conclude that low-wages are the problem and wages need to rise or else people will opt out.

Infographic: Yellen takes a turn down Main Street

What do Yellen’s motives mean for markets?

We can conclude that Yellen wants to see real wages rise materially higher over the next few years. This doesn’t mean that she will wait for wages to rise before rates begin to increase, but it does mean she will tolerate higher wage inflation across the cycle.

Low wages in America are not the unintended consequence of policy – they are the direct result of policy. In the past two decades, each recession has reduced the bargaining power of the average guy because higher unemployment forces wages down and, at each upswing, when the economy recovers he is starting from a weaker position than before.

This means that the crunch of economic adjustment has been borne disproportionately by workers. Low wage inflation, rising inequality, stagnant productivity and reduced labour participation, all reflect this truth. So too does the rising level of corporate profitability, elevated share prices and maybe most conspicuously, the emergence of massive cash war-chests being built up by corporate America.

This doesn’t sit well with Yellen’s intellectual DNA. As a result, she will want to see sustained increases in real wages before choking off the recovery with higher rates. Material rises in real wages, with an inflation target of 2%, means nominal wage growth of c. 4% on average over a sustained period. This also implies pushing the level of unemployment lower than it is today.

Getting off zero is essential – not least because the Fed will want positive nominal rates to be able to cut the next time the US has a recession (which inevitably it will). The Fed also wants inflation to be materially higher as the cycle matures again, because it will need an elevated level of prices from which to disinflate in the next downturn.

Yellen as a New Keynesian believes in the Phillips Curve. She appreciates that there is a tradeoff between inflation and unemployment, but it may be that she is less concerned about inflation than the bond market is comfortable with, particularly at current yields.

All this implies that under Yellen, the doctrine of pre-emptive tightening – much loved by the bond market evangelists – is dead. So too is the notion that inflation should not rise cyclically during recoveries.

Of course, inflation should rise. In fact, sustainable wage inflation is the sign of a successful economy.

This also implies, that the Yellen-led Fed will try to normalise rates this year but then be slow to hike aggressively thereafter, because it wants higher nominal wages to work their magic.

Joining the dots

This brings me finally, to the gap between the Fed’s ‘dots’ and the markets’ own view of where rates are likely to be in the next few years.

We should remember that:

  • these dots are not policy but merely opinions by voting and non-voting Fed members about where rates might be
  • the Fed has only being talking ‘dots’ since 2012, which is hardly enough time to suggest that there is anything divine about their impact on likely policy
  • Yellen may well rue the day the ‘dots’ were introduced into the policy making framework

At the moment the gap between the market and the ‘dots’ is worrying many investors as it may presage bond and credit market carnage, if the Fed does indeed hikes rates according to the ‘dots’.

However, I believe, taking together what we know about Yellen and her view of the US economy, that the ‘dots’ tell us where the Fed thinks inflation (not rates) will be – and the interest rate implication of that rate of inflation is based on a historic view of how the Fed reacts to inflation.

But if a Yellen-led Fed is more chilled about inflation because it wants short-term real wage growth to boost long-term productivity, we are in a different world.

Given this, expect the yield curve to steepen when the bond vigilantes come out from the shadows and realise they are dealing with a very different Fed Chair than anything that has gone before.

This may in turn cause wobbles in equity markets but, once it becomes clear that real wages need to rise in the US and that the next battle is not against 1970s style inflation but about re-creating 1950s style modest prosperity, markets will adjust, as they always do. Longer term, the gradual reallocation of returns, from capital back to labour, is likely to have profound implications for corporate profitability, margins and, in turn, sustainable equity market valuations. All the more reason to be investing with perception, discipline and conviction, therefore, in a troubled and distorted world.

David McWilliams (Twitter: @davidmcw) is one of Ireland’s leading economic commentators and was the first economist to identify the Irish boom as nothing more than a credit bubble, warning of its collapse and the consequences for the country. His objective is to make economics as widely available and easily understandable on as many platforms as possible. His daily market commentary www.globalmacro360.com is read by tens of thousands of his over 230,000 Twitter followers.

Woodford Investment Management Ltd is authorised and regulated by the Financial Conduct Authority (firm reference number 745433). Incorporated in England and Wales, company number 10118169. Registered address 9400 Garsington Road, Oxford OX4 2HN.

Woodford Patient Capital Trust plc is incorporated in England and Wales, company number 09405653. Registered as an investment company under section 833 of the Companies Act 2006. Registered address Beaufort House, 51 New North Road, Exeter, EX4 4EP.

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