Still no sign of wage inflation — only a broken link
Sept. 10, 2015
As the Federal Reserve ponders raising rates, we believe the only thing supporting such an action is the unemployment rate, which is currently at levels consistent with the nonaccelerating inflation rate of unemployment (NAIRU), referring to a level of unemployment below which inflation rises. Chart 1 illustrates that while the widely followed U3 (or official) unemployment rate has converged with its pre-crisis level and the Congressional Budget Office’s (CBO’s) estimate of the long-term natural rate of unemployment, broader measures of unemployment, such as U6, indicate that slack still remains in labor markets. (The U6 unemployment rate accounts for worker detachment and part-timers due to economic reasons.)
Chart 1. Average, current, and natural unemployment rates
Sources: Bureau of Labor Statistics and Congressional Budget Office, September 2015
The theory behind a potential rate hike is that falling unemployment pushes up prices and wages, requiring tighter monetary policy to keep inflation in check. However, history shows that when the unemployment rate has moved below NAIRU, wages and inflation pressure have not necessarily followed. Since 1960, there have been six wage cycles when the unemployment rate moved below NAIRU (using the CBO estimates of the natural rate of unemployment). The orange line in both panels of chart 2 denotes the unemployment gap, calculated as the unemployment rate minus NAIRU. We note that prior to 1990, wages and inflation moved up when the unemployment gap was negative. However, post-1990, the response has been more muted.
Chart 2. The connection between wages and inflation in recent years has been muted
Sources: Bureau of Labor Statistics and Bureau of Economic Analysis, September 2015
This suggests that the relationship between labor slack and inflation (the famous Phillips curve, or the historical inverse relationship between rates of unemployment and corresponding rates of inflation) is not stable through time. We highlight that in the 1970s labor unions had negotiating power, and after 1990 globalization and productivity developments took hold. In fact, when looking at the relationship between core inflation and the unemployment gap through regression analysis across different time frames (see Chart 3), two observations emerge:
- The dispersion of the data around the statistical best-fit line is notable, regardless of the time frame examined. This implies that we cannot say with confidence the exact levels at which inflation pressures emerge given “x” level of unemployment gap.
- The coefficient has become significantly weaker over time (-0.1824 for 1997–2015, compared to -0.5695 prior to 1968). This means that the expected sensitivity of inflation to falling unemployment has decreased by 68%, comparing on a percentage basis the recent coefficient versus the one prior to 1968.
Chart 3. Core inflation and the unemployment gap
Sources: Bureau of Labor Statistics, Congressional Budget Office, and Bureau of Economic Analysis, September 2015
To better understand the relevance of these observations, let’s go through the math implied by the Phillips curve, using the more recent statistical regime of 1997–2015. The unemployment rate has been at or below 5.7% since October 2014. The most recent reading from the Bureau of Labor Statistics was 5.3% for both June and July 2015. The CBO estimate of the natural rate of unemployment is 5.4%, and most NAIRU references fall in the range of 5.0–5.5%. If we assume the Phillips curve relationship between the unemployment gap and core inflation (y = -0.1824x +2.21, where y = core inflation, and x = unemployment gap), core inflation should have been north of 2%. However, the actual inflation data show that core personal consumption expenditures (PCE) has been missing the Fed’s 2% target for 38 months and counting (see Chart 4).
Chart 4. Core inflation remains well below the Fed's long-term target
Source: Bureau of Economic Analysis, September 2015
Turning to measures of wage growth, there is no indication of imminent upward pressure, as implied by a traditional unemployment gap framework. In fact, wage data also seem to be turning weaker. Chart 5 shows average hourly earnings for nonsupervisory workers (AHE), the Employment Cost Index (ECI, which measures salaries and benefits), and the Bureau of National Affairs’ Wage Trend Indicator (a broad measure of private industry wage trends). Note that wages are currently 1.0–1.5% below average levels that existed prior to the global financial crisis. Looking at wage trends, while the Wage Trend Indicator has been improving, it remains below levels consistent with 3% wage growth.
Chart 5. Wages remain below their long-term trend
Sources: Bureau of Labor Statistics and Bureau of National Affairs, September 2015
Finally, we want to highlight the changing correlation between wages and inflation. The breakdown fits with the decline in union power and the globalization theme. Visually, inflation and wages were closely moving together prior to the emergence of China and globalization, prior to the emergence of China and globalization, prior to the emergence of China and globalization, which followed the end of the Cold War (Chart 6, first panel). In the early 1990s, the relationship between wages and inflation became noisier. This breakdown in correlation is nicely captured in the periodic correlation study shown in the table below the graphs. Prior to 1990, the correlation was 0.72 between average hourly earnings and core PCE. Between 1990 and 2007, the correlation dropped to -0.07! This period also coincides with the significant divergence between wages and corporate profits, as a share of gross domestic product (Chart 6, second panel). Following the global financial crisis, the divergence widened further, while the correlation changed sign to a negative 0.61.
This supports our view that labor slack remains and negotiating power for higher wages is relatively weak.
Chart 6. Wages and inflation
Divergence between wages and corporate profits
|AHE YOY correlation vs:
|Core PCE YOY
Data: Bureau of Labor Statistics, Federal Reserve Bank of St. Louis, September 2015
Given this backdrop, we go back to the July 2015 Federal Open Market Committee (FOMC) statement and quote the following paragraph:
The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.
… and conclude that inflation remains nowhere to be seen.
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All charts shown throughout are for illustrative purposes only.
The views expressed represent the Manager's assessment of the market environment as of September 2015, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
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