How does the Fed determine policy if asset prices are too high and wage growth is stagnant?

There is a substantial relationship between economic growth and the performance of financial markets where the stock market responds to futures in the economy not to its past performance.

Economists refer to this trend in financial markets as the difference between trailing and leading economic indicators. In essence, financial markets track leading economic indicators making projection of where the economy is headed. There are hundreds of economic indicators; but focusing on a few can provide important trends to make economic predictions.

For instance, unemployment rate in relation to full employment describes the curve consistent with what is considered full employment and wage pressures on the labor market. Financial markets will diligently review reports of jobless claims, the employment cost index and others statistics related to labor markets. Because labor costs represent roughly 70% of all production costs in the U.S., anything that leads to higher wages will mean higher production costs and more likely than not passed on as higher consumer prices of goods and services. Even small changes in any of these indices can send financial markets into turmoil.

In Economic theory the cost of production measures prices of inputs such as labor and raw materials costs to determine how those inputs affect the final price of producing goods.

Commodity production such as steel, paperboard, copper agriculture is at capacity, logjams will occur if additional demand increases for these commodities. Once all of the available capital is in use, output can only be increase by increases in capital or labor or both are added. This increases production costs, that in turn must be passed on to the users of these commodities and finally to the consumer of the finished good. Other indicators such as factory orders and durable goods orders can provide signs to the direction of commodity prices in the future.

The Producer Price Index (PPI) is a very useful leading indicator of price indices. The PPI tells us about changes in input prices that production is paying. Increases in the PPI are soon passed to the Consumer Price Index (CPI).

Positive variation in firm’s inventories indicates consumer demand for goods remains strong. In contrast, growing inventory levels might signal a weakening economy, production slowdowns and worker layoffs until the trend changes for a season of consumer consumption. The current consensus for full employment is on or about 4%- 4.2%.

The Federal Reserve Bank will raise interest rates when inflationary pressures are rising, or, if economic growth is weak and inflation low, the Bank will lower interest rates. Financial firms try to guess what the Fed’s next move will be in a a given a set of economic indicators and don't wait for the actual move always trying to make educated guesses and act as if the Fed’s will actually raise, lower or leave interest rates unchanged.

The reason is explained by the inverse relationship of bonds to market interest rates. Interest Rates have an inverse effect on the stock market as well. Rising rates almost always lead to lower stock prices as the overall market drops.

Economic theory also makes important distinctions that separate one market scenario from another:

· The amount of sluggishness in the economy, or in contrast how close the economy is to full employment and full use of its productive capacity for example at capacity utilization of 84%.

· The ratios between the amounts of growth-rate-of-aggregate-demand to aggregate-supply-growth. Aggregate supply growth is constant from year to year and reflects the economy's supply side growth of approximately 3% which equals:

Measuring a National Economy

GDP = C + I + G + NX

GDP, output, total income, total expenditure

C = consumption

I = investment

G = government purchases of goods and services

NX = export – imports

GDP: = The market value of final goods and services, newly produced within a nation during a fixed period of time.

Aggregate demand: = is altered by changes in fiscal policy (taxes (T) and government spending (G) and changes interest rates (r).

Stagnation of Wages Causation

Weak wage growth has had multiple reasons that can be traced back to the 1970′s. Historical statistics indicate that from 1948 until the early 1970′s, wages rose together with productivity. Nonetheless, since 1973, productivity has grown 72% while wages are up by merely 9%.

Income inequality has had an even wider gap. The top 5% of workers saw their wages increase by 60% since 1973 but the top 1% gained a 138% increase. Today, Fortune 400 CEO’s earn 296-times the average American wage—up from 24-times in 1973.

Globalization has been blamed for the decay on wages and on the sharing of productivity wealth but the catch in economic terms, is that cheap imports have provided Americans with lower prices offsetting somewhat the dysfunctional growth in wages.

Moreover, if the US takes a protectionist path, it would contract trade and push up the price of imports. Protectionist measures such as tariffs would negatively impact economic activity and diminish corporate profits. Tariffs are likely to encumber, not help, wage growth. Income inequality is also a tough fix.

A major reason for income inequality is the Federal Reserve’s ease with monetary policy. Thirty-five years of sinking interest rates and multiple spells of asset purchases have inflated asset prices but it has done little to increase wages.