Summary

• Long run equity returns will be in the low single digits from where the market is right now.
• The Federal Reserve should only justify raising rates in response to rising wage growth as a return to one of its core responsibilities.
• The Federal Reserve can either continue on the current path or take action. Either response will be hard to justify.

The key to the Federal Reserve’s decision of when to start raising interest rates is based on wage growth. The rate of unemployment is not trusted as a reliable indicator of labor market tightness, but an increase in wages will represent a clearer sign that labor market slack has been absorbed. Failure to respond to accelerating wage growth could be very damaging to the Federal Reserve’s credibility and its commitment to limiting inflation. Yet, leaning against increased wage growth could have some undesirable consequences and make the Federal Reserve complicit in sustaining a key imbalance in the economy.

A striking feature of the United States economic landscape during the past few years has been dramatic shifts in the income shares of capital and labor. From 1950 to 2000, both employee compensation and the corporate sector’s gross operating surplus as percentages of corporate GDP fluctuated within relatively narrow ranges and were mean reverting. However, beginning around 2000, the employee compensation share began to plunge while the returns to capital soared. The employee and corporate income shares currently are around a multiple standard deviations from their means of 1950 to 2000.

Historically, there was a relatively stable relationship between the income shares of compensation and profits because real compensation tended to move closely in line with productivity. This meant that both employers and employees shared the benefits of efficiency gains. However, this relationship broke down during the past few years with a large wedge opening up between productivity and real compensation. Meaning laborers have constantly become more efficient yet getting paid less. Companies increasingly were able to capture a disproportionate share of productivity benefits, to the detriment of employee compensation and thus household living standards. The reason why this occurred is not clear but has partly reflected the combination of labor-saving technological innovations, competition from cheap labor overseas and, after 2008, and considerable labor market slack. The weakness in wage growth has been broadly based across industries and occupations, suggesting that globalization and technology have not been the only factors at work.

Profit margins are affected by a myriad of factors beyond just the level of economic activity. For example, tax rates shifts, depreciation policies, interest rates, and the exchange rate can all have an impact. We can abstract from these forces by looking at the trend in domestic non-financial profits, before interest, taxes and depreciation (EBITD). This measure is most directly affected by underlying economic trends — sales, productivity and prices.

The growing gap between real compensation and productivity largely explains the unusually high level of profit margins.

The current level of real compensation would be around 10% higher if it had maintained its historical relationship with productivity during the past decade. If that were the case, then EBITD margins currently would be almost exactly in line with their historical average, as opposed to four standard deviations above.

What does this mean for future actions?

The Federal Reserve and markets may take comfort from the fact that wage growth has remained subdued, but this reflects an unusual dislocation in the economy. Of course, sluggish wage growth has been good for profits and the stock market, but it has been bad for real incomes and consumer spending. If wages were to start making up some of their lost ground relative to productivity, would that be such a bad thing? We can assume that companies will always try to maintain net profit margins, so are inclined to raise prices when they can in response to increased cost pressures. The global environment remains highly competitive and the general problem right now is inadequate demand, rather than a lack of resources. The annual growth in the prices of traded manufactured goods is stuck at near zero while the median inflation rate for 34 OECD countries is less than 1%. And let’s not forget that margins are high and thus will likely be increasingly difficult to sustain going forward.

If wage trends are going to be a key determinant of Federal Reserve policy, then there is a risk that policy could be tightened prematurely. Some argue that wages are a lagging indicator of inflation so by waiting for wage growth to rise, the Federal Reserve is guaranteed to be acting far too late. On the other hand, the cost-push view of inflation treats wages as a leading indicator of price pressures. In reality, the annual growth rates for wages and consumer prices are largely coincident.

Monetary policy is aimed at delivering the optimal economic outcome but can only do so through a one-size-fits-all policy and is not geared toward producing winners and losers in society. However, that claim cannot be made with regard to policy actions in recent years.

The Federal Reserve’s role in financial bailouts most definitely involved picking winners and losers. For example, Lehman Brothers was allowed to fail, wiping out shareholders and bondholders, while Goldman Sachs (NYSE:GS ) and Morgan Stanley (NYSE:MS ) were granted banking licenses, enabling them to access the Federal Reserve’s discount window. Moreover, non-financial companies could feel aggrieved that the Federal Reserve has gone to great lengths to boost bank profits by engineering a steep yield curve, but have left Main Street companies to largely fend for themselves.

Pushing interest rates to zero and targeting 2% inflation hurts savers, especially those dependent on fixed incomes, and benefits borrowers, some of whom behaved recklessly during the boom years. Finally, a principal aim of quantitative easing has been to push up asset prices and the major beneficiaries of that are the wealthy who account for a large share of equity ownership.

The Federal Reserve would argue that it has not set out to pick winners and losers, but there is no doubt that current policy is aimed at transferring wealth from creditors to debtors. That may be justified as being all for the greater good by keeping the economy out of a deflationary slump, but it brings monetary policy at least partly into the traditional realm of fiscal policy.

The Federal Reserve would justify raising rates in response to rising wage growth as a return to one of its core responsibilities — to controlling inflation. If companies are restricted in their pricing power, then faster wage growth would not lead to a big inflation problem and it would help reverse the current unsustainable divergence between the income shares of labor and capital. If the Federal Reserve leans against improved wages in a disinflationary world, it could again represent monetary policy having unwelcome distributional effects.

The Federal Reserve will be in a difficult position, whatever path it chooses to follow. If it ignores faster wage growth, then its credibility could be undermined and inflation expectations could rise considerably. If it responds to faster wage growth by raising rates, then it runs the risk of undermining the economy unnecessarily. The weakness in wage growth is at least partly due to structural forces and there is not much that the Federal Reserve can do about that. In some ways, the technological and global forces that are depressing employee compensation give support to the idea that the global economy may struggle to return to more normal growth rates.

A final thought on corporate profits is warranted. The current extremely high level of margins is not a reflection of some miraculous efficiency gains on the part of companies that warrants optimism about the sustainability of strong profit growth. It reflects a set of circumstances that has allowed companies to keep wages down, thereby enabling them to capture a disproportionate share of productivity. This does not seem a sustainable state of affairs.

At some point, at least a partial reversal of the divergence in income shares between capital and labor is inevitable. The implication is that investors should assume very modest earnings growth over the medium term — probably no more than 5% a year in nominal terms. With multiples also likely to contract from current elevated levels, long-run total equity returns will be in the low single digits from the market’s current point.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More. ) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.