Today, we received another jobs report showing that the labor market remains red hot. Unemployment fell to 3.4%, a 54-year low. Job growth was 253,000, which is well above trend and well above pre-report estimates.

By far the most important data point, however, is the growth rate of average hourly earnings. Nominal wages grew at a 6% annual rate in April, well above expectations. (The 12-month growth rate ticked up from 4.3% to 4.4%.) For a Fed that is trying to slow the growth in aggregate demand, this is bad news. For the purposes of monetary policy, wage inflation is the only inflation rate that matters.

Why does the economy remain so hot, despite more than a year of “tight money”? Is it long and variable lags? No. A truly tight money policy reduces NGDP growth almost immediately. The actual problem is a misidentification of the stance of monetary policy.

I’ve discussed this issue on numerous occasions, but people don’t seem to be paying attention. So perhaps a picture would help. In the two graphs below I provide typical examples of a tight money policy and an easy money policy. Note that what really matters is the gap between the policy rate (fed funds rate) and the natural interest rate.



It’s not always true that a period of tight money is associated with falling interest rates, but that is usually the case. Does that mean the NeoFisherians are correct—that lower interest rates represent a tight money policy? No. For any given natural rate of interest, lowering the policy rate makes monetary policy more expansionary. That fact is clear from the way that asset markets respond to monetary policy surprises. But when the natural rate is falling (often due to a previous tight money policy), the policy rate usually falls more slowly. To use the lingo of Wall Street, the Fed “falls behind the curve.”

The opposite happened during 2021-22, when the Fed raised rates more slowly than the increase in the natural interest rate. In this case, it wasn’t so much the pace of rate increases, which was fairly robust, it’s that they waited too long to raise rates, by which time the natural interest rate had already risen sharply.

P.S. The natural rate cannot be directly measured; we infer its position by looking at NGDP growth. That’s why I ignore interest rates and focus on NGDP.