Should Monetary Policy Target Labor’s Share of Income?

In recent work, Woodford (2001) presents evidence that using real unit labor costs (labor’s share of income) as a driving variable in the new-Keynesian Phillips curve yields a superior fit for inflation relative to a model that uses deterministically detrended real GDP. This evidence leads him to conclude that the output gap—the deviation between actual and potential output—is better captured by the labor income share, in turn implying that the monetary authority should raise interest rates in response to increases in this variable. We document that the empirical case for the superiority of the labor’s share version of the new-Keynesian model is actually quite weak, and conclude that there is little reason to view the labor income share as an appropriate target for monetary policy. ∗Mail Stop 80, 20th and C Streets NW, Washington DC 20551. E-mail: [email protected]. We are grateful to Argia Sbordone and Michael Woodford for helpful comments on an earlier draft of the paper. The views expressed in this paper are our own and do not necessarily reflect the views of the Board of Governors or the staff of the Federal Reserve System.