- The labour market is the strongest it has been for decades
- But a ‘strong’ labour market is not the same as a ‘tight’ one
- A clear sign of this is that wage growth – and the labour share of income – is lower than would be expected at this stage in the cycle
- Well-anchored inflation expectations, ‘hidden slack’ in the labour market, and a lower NAIRU are likely keeping a lid on wage growth
- Globalisation and lower trade union membership appear also to have reduced the bargaining power of labour
- The lack of significant wage pressures means that upside risks to the Fed’s rate hike projections are limited, in our view
The lack of wage growth has been a puzzle for economists
Labour market developments are crucial for the path of monetary policy. As well as being an explicit goal of the Fed’s (to foster maximum employment), the labour market is a key driver of its other goal – price stability. Although a key input into the Fed’s decision-making, the labour market is also at the heart of a topic that has arguably vexed economists the most in recent years – the ‘puzzle’ over subdued wage growth (and in turn inflation), despite what appears to be a historically tight labour market: the so-called flattening Philips curve. In this note, we decompose this apparent puzzle, and discuss the implications for monetary policy.
The labour market is strong – of that there is no doubt…
By most measures, the labour market is very strong. In May, the unemployment rate fell to 3.8%, the lowest in 49 years, and after picking up again to 4.0% in June is still well below levels that prevailed leading up to the crisis (pre-crisis, unemployment troughed at 4.4% in early 2007). The broader U-6 measure of unemployment, which includes involuntary part-time and discouraged workers (i.e. those who want (more) work but have given up looking) is near a 17 year low at 7.8%. This measure has become a bigger focus as the headline unemployment rate continued to fall without significant accompanying wage growth, often cited as a sign of ‘hidden slack’ in the labour market – an issue we will explore later.
Beyond the low unemployment rate, there are other signs of exceptional strength in the labour market. Weekly claims for unemployment benefits have fallen to the lowest levels since 1969, and when adjusting for growth in the labour force since the 1960s, are the lowest since records began. Job vacancies as measured by the JOLTS report are also at all-time highs – both nominally and when adjusting for labour force growth. Indeed, in March this year, a key milestone was reached when the number of job openings exceeded the number of unemployed – for the first time since the Bureau of Labor Statistics started collecting such data in 2000.
…and that strength is likely to persist
We expect the strength in the labour market to continue for at least the coming year, supported by strong growth momentum – led by investment, as well as higher government spending. As a result of the supportive macro environment, we expect monthly payrolls growth to average 227k this year – which would be the fastest employment growth since 2014. We project unemployment to fall to 3.1% by end-2019, which would be the lowest since 1953.
But where is the wage growth?
The strong labour market is likely to drive a further pickup in wage growth, but that as with much of this cycle, the pace of the acceleration will continue to be gradual. Wage growth is at present by no means low – merely underwhelming, considering the strength of other labour market indicators. Having picked up from c.2% from 2010-2014 to a 2.5-2.7% range since 2016, wage growth has failed to accelerate meaningfully further, and remains below the pre-crisis 3-3.5% range – despite the continued decline in unemployment (see figure on p1).
However, business surveys (for instance from the small business NFIB) suggests the pressure on business to raise wages continues to build, and there are also more qualitative signs of a shift in wage-setting behaviour. For instance, Costco is the latest among large retailers to significantly raise starting minimum wages – from $13 per hour to $14 – a 7.7% rise. This followed similar moves by the US’s biggest single employer, Walmart (which has raised wages from $10 to $11 per hour – a 10% rise), and Target (which is raising wages in stages to $15 per hour from $10 by 2020 – a 50% rise over three years). As such, while the aggregate data remains tame for the time being, there are clearly pockets where strength in the labour market appears already to be boosting wage growth.
Productivity is the long-term driver of wage growth
What explains the very slow pickup in wage growth, despite such an apparently tight labour market? As discussed in the Box on the Phillips curve on page 2, we think the main reason is the fall in inflation expectations. However, this is likely not the only explanation. We will now explore some of the other likely drivers.
One driver often cited for the lack of wage growth is weak productivity growth, which has averaged just 0.8% (annualised) over the post-crisis period, down from 2.7% pre-crisis. Over the long run, productivity growth is indeed the necessary pre-condition for (real) wage growth, and in his Testimony to Congress this week, Chair Powell responded to a question on wage growth in exactly such terms. However, low productivity growth cannot explain the entire story, because it is not only wage growth that is subdued, but also labour’s income share of national output (defined in the US as total employee and proprietor compensation as a percentage of gross value added). This has seen a structural decline since the early 2000s from a 60-63% range to a remarkably stable 56-57% range in the post-crisis period, with little sign of any cyclical upswing (as of Q1 18, it is stuck at 56.6%). Meanwhile, the share of corporate profits has correspondingly increased.
The low labour share suggests residual slack, and less bargaining power
Were the labour market truly as tight as it appears, labour should have the theoretical bargaining power to get a bigger piece of ‘the pie’, even if low productivity growth means that pie is growing at a slower pace than it was previously. Indeed, historically speaking, the labour share has typically moved higher towards the end of the economic cycle, but this has yet to happen in the current cycle. The lack of such a pickup suggests: 1) there is still slack in the labour market, 2) the bargaining power of labour is lower, and/or 3) the so-called ‘natural’ rate of unemployment is lower than official estimates. In the final section of this note, we explore each of these potential causes of weak wage growth.
1) Residual labour market slack
Labour force participation has increased recently, and this has slowed the decline in the unemployment rate. The rise in partipation is being driven by the return of prime age (ages 25-54) workers to the labour force, which is offsetting the departure of ‘baby boomer’ older workers . Participation of prime age workers had declined in the early post-crisis period, and although picking up recently, it remains below pre-crisis levels. Should such workers continue to return to the labour market, this should ease the upward pressure on wage growth.
One reason for the return of prime age workers could be the decline in disability benefit recipients. The number of benefit recipients has fallen over the past few years – reversing a long trend of ever-increasing numbers. Having peaked at 8.96mn in September 2014, recipients fell to 8.63mn as of May 2018, while applications fell from c.2mn in 2011, to just under 1.5mn in 2017 – the lowest since 2002. This points to further declines in recipients over the coming months.
There are both ‘carrot’ and ‘stick’ reasons for the decline. First is the strength of the economy, which has made employers more willing to draw on different labour pools and to be more accommodating. Another ‘carrot’ is that with the expansion of health insurance via Obamacare, there is less incentive to apply for disability benefits purely for healthcare coverage. At the same time, there is evidence that the Social Security Administration has made it harder to qualify for benefits, and appeals judges taking a more skeptical stance . All told, the reduction in disability benefit recipients increases the pool of workers employers can draw on, which should moderate wage growth.
2) Weaker bargaining power of labour
The bargaining power of labour is also arguably lower than in the past, which we attribute to: 1) lower trade union membership, and 2) globalisation.
First, union membership has declined substantially, from a peak of 32.5% of employees in 1953, to just 10.7% as of 2017 – with the steepest falls occurring in the 1980s (see figure below). As well as lowering wage-bargaining power, lower union membership has likely made it easier for companies to make workers redundant, which all else equal increases the supply of workers at a given time.
Globalisation has also likely reduced bargaining power. There are three main channels:
• Trade: Following the reduction of trade barriers, companies have been able to import cheaper goods from other jurisdictions. This exposes domestic goods producers to higher levels of competition, lowering pricing power, and in turn wage demands (i.e. workers in an industry exposed to intense international competition would likely be more reluctant to demand bigger pay rises).
• Immigration: When companies face skills shortages in the local pool of labour, they no longer (necessarily) have to raise wages in order to attract domestic workers, but instead can employ a worker from overseas. This channel can affect both skilled and unskilled wages, and should work to dampen overall wage growth.
• Outsourcing: Something that primarily affects lower skilled wages (think of call centre workers), but also some higher skilled (eg. in the IT sector). As with immigration, this can work to dampen domestic wage growth by giving businesses the option to move jobs overseas as an alternative to hiring domestic workers.
These channels can reduce wage pressure both from the demand side and the supply side. From the demand side, demand for domestic labour market is reduced, lowering wage growth. From the supply-side, weaker cost growth for business are a disinflationary force for goods and services, which keeps inflation expectations in check – in turn dampening wage growth.
Indeed, because of the wide-ranging impact globalisation can have on the labour market, it is arguably becoming increasingly untenable to view national domestic labour markets as fully distinct from the global labour market. As such, it may make more sense in future to think of a ‘global’ Phillips curve that takes into account global levels of labour market slack – something of a moving target given the (at least until now) ever-increasing integration of the global economy.
3. A lower ‘natural’ rate of unemployment
A more long-term and much bigger structural change in the labour market is the educational attainment of the labour force, which has increased significantly in recent decades. Indeed, this has been highlighted in the FOMC minutes and by Fed Chair Powell in his June FOMC press conference as a possible reason for the decline in the NAIRU (non-accelerating inflation rate of unemployment) – sometimes referred to as the ‘natural’ rate of unemployment. The theory is that, because unemployment rates are typically lower among more highly educated cohorts, a more educated workforce should (all else equal) have a lower unemployment rate for a given stage of the economic cycle.
The data indeed appears to support this theory. The longterm average unemployment rate for college graduates is just 2.8%, for high school graduates 5.7%, and for non-high school graduates 9.1% (average rates since 1992, when collection of this data began). Meanwhile, the college graduation rate has risen more than 10 percentage points over the past 20 years, from 23.9% in 1997, to 34.2% in 2017. For high school leavers, the graduation rate has risen from 82.1% in 1997 to 89.6% in 2017. With the proportion of both high school and college graduates increasing so much, this has likely put structural downward pressure on the unemployment rate, and in turn the NAIRU.
But why might it be the case that the unemployment rate is lower among more educated workers? And how would this dampen wage growth? One reason for lower unemployment rates is that more educated workers are likely more able to adapt to structural changes in the economy; for instance, when an industry or profession becomes obsolete (or shifts overseas), more educated workers are likely more capable of retraining to work in new industries. A more educated workforce can therefore dampen wage growth by raising the supply of more flexible, adaptable workers.
This is probably at least partly why the NAIRU is likely lower than the 4.6% that is currently estimated by the Congressional Budget Office. Should the NAIRU be much lower than estimated, unemployment could at some point in the coming years fall even below the all-time low of 2.6% recorded in 1953, only without the accompanying high (wage) inflation of that period.
Conclusion: More slack than appears, but the Fed to keep hiking
In this note we have made the case that there is likely considerably more slack in the labour market than is suggested by the headline unemployment rate alone, and that the relationship between slack and wage growth is weaker than in the past. As a result, we see scope for the unemployment rate to move well below levels that have typically prevailed at the peaks of the economic cycle, and without significant accompanying inflationary pressure.
What does this mean for the Fed, and for the path of interest rates? With policy probably still somewhat accommodative at current levels, we believe the Fed will continue to raise rates towards and a bit above its estimate of the ‘neutral’ rate (2.9% as of the June FOMC) over the next 12 months – we project four further 25bp rate hikes, taking the upper bound of the fed funds rate to 3.00% by next June . As Chair Powell highlighted at his most recent FOMC press conference, it is not only labour market and inflation developments that the Fed takes into consideration, but also the potential buildup of financial stability risks that may accompany an overly accommodative policy stance (see here). The Fed is likely to want to pre-empt any build-up of such risks.
However, while we expect wage growth to continue to pick up, which should in turn support core inflation, we do not foresee a dramatic acceleration on our forecast horizon (to end 2019). As such, we think the Fed is unlikely to want to push much beyond its neutral rate estimate, nor to hike at a quicker pace than once per quarter.