Recently some Fed policymakers have noted that if “…the unemployment rate continued to decline quickly this could raise wages and price inflation more quickly than anticipated”. Historical data suggest that when the unemployment rate falls below the 6% threshold, wage growth accelerates. Up to now unemployment has been falling rapidly and is currently at 5.6%, while wage growth, on any measure, has been weak. We think that we are at the turning point where labour market tightening will trigger broad, but modest wage gains in 2015. We expect a tighter labour market will prompt the Fed to hike rates in mid 2015 even if wage gains by then will only have had a small impact on consumer price inflation. This is consistent with the gradual pace of rate hikes which we have forecasted after the rate lift-off in 2015 and the faster pace of rate hikes in 2016.
Wage growth sluggish despite strong labour market
Until recently, there has been a relative weakness of wage growth compared to the strength of labour market indicators. For Fed Chair Janet Yellen, the sluggishness in wage growth is partly explained by pent-up wage deflation. This suggests that many firms were unable or unwilling to lower compensation during the recession and the earlier part of the recovery and are therefore not yet inclined to raise wages significantly. At the same time, Yellen has mentioned that transitory pressures could emerge well before maximum sustainable unemployment has been reached, given the structural impediments to reemployment that are still lingering as a result of the Great Recession. We think that given the long period of wage sluggishness, a modest acceleration of wage growth will likely increase consumer spending and gradually raise inflation pressures even if in the short term this relationship will not be too strong. This macro focus addresses whether the behaviour of nominal wage inflation is unusual relative to the current measures of labour market slack and to what extent nominal wage inflation will impact price inflation, since price inflation is key to the Fed’s dual mandate.
Diminishing labour market slack to push up wage growth
In the US, there is a clear relationship between wage inflation and unemployment. However, the relationship is nonlinear, which means that at lower levels of unemployment, wages tend to accelerate more rapidly. Concretely, historical data suggest that when the unemployment rate falls below the 6% threshold, wage growth accelerates. The question is where the turning point now is in this relationship. The graph below shows that we don’t have a precise understanding of the point at which this will take place, but there has already been some progress in moving to the steepest part of the curve. Unemployment has been falling rapidly in the past months and is currently at 5.8%. In fact, we are seeing a pick-up in some measures of wage growth.
Different measures of wages are starting to pick up
There are a number of indicators that measure wage growth. The differences among the indicators are derived from the category of industries that are covered and whether these measures only include wages or other measures of compensation as well. We focus on some of the most commonly used indicators. Average hourly earnings, which is a measure of gross pay divided by total hours paid, is a partial indicator given its coverage as it is calculated before taxes and other deductions. A more comprehensive measure of wages is the employment cost index. This index measures total compensation wages and salaries as well as benefits. Benefits include paid leave and other supplementary pay. Many analysts, including the Fed, consider that the employment cost index is the most reliable measure of labour costs. Finally, unit labour costs are calculated based on the difference between compensation costs divided by output per hour (productivity). This measure also takes productivity growth into account, which is also critical when evaluating the impact of wages on inflation. That is to say an increase in wages which is matched by an increase in productivity should not impact inflation.
When comparing these wage measures, all three measures show that wages have been subdued in the past years, remaining far below the long-term average. But most are starting to recover. The employment cost index (ECI), which is more appropriate for forecasting future wage inflation, has shown the fastest increase in the past few months. Still, growth rates remain modest. For some, even the modest acceleration is already evidence of diminishing labour market slack.
Moreover, surveys of small businesses suggest that they plan to increase compensation in the coming months. But we think there are certain restraints to rapid wage growth, including low inflation expectations as a result of lower energy prices. We expect the growth momentum of wage gains to be around 3% at the end of 2015, but that growth will remain modest in the first half of the year. This is the lower bound of the 3-4% rate that Fed Chair Yellen has identified as normal.
Moderate rise in wage growth suggests impending Fed rate hike…
Chair Yellen has included wage growth in her labour market dashboard and follows closely the cyclical but also secular trends that are affecting the evolution of wages in recent years. Recently, some Fed policymakers have noted that the uptick in the ECI could be a tentative sign of an upturn in wage growth. In any case, the labour market improvement has gone beyond Fed policymakers expectations. Since October, the unemployment rate (now at 5.6%) has been falling faster than the central tendency projections of the FOMC, forecast at 5.8% in the fourth quarter of 2014. Our forecasts indicate that unemployment will continue to decline this year from 5.8% to around 5% at year-end. The Fed expects unemployment to reach around 5.2% at the end of this year, approaching the normal long-term unemployment rate.
…even if inflation remains low
The impact of wage gains on consumer prices will depend on whether wage gains exceed productivity growth and on the path of import prices. In the past years, compensation has been outpacing productivity, which has had a modest impact on unit labour costs. Since we are not expecting major shifts in productivity, the acceleration in wage growth will push up unit labour cost and hence core inflation. However, the decline in oil prices and the stronger dollar continue to push down import prices. So we think that an increase in consumer spending will still have a minor impact on inflation.
The latest FOMC minutes were quite revealing in this respect. Even if wages show a moderate growth and headline inflation does not move close to the Fed 2% target, Fed policymakers have noted that this should not be an impediment to normalising interest rates. We expect a tighter labour market will prompt the Fed to hike rates in mid 2015 even if wage gains will by then only have had a small impact on price inflation. Indeed the Committee mentioned that “they might begin normalisation at a time when core inflation was at current levels”.