Written exclusively for InTouch Capital Markets
6th April 2018
By Steven K. Beckner
One reason the Federal Reserve has kept interest rates relatively low and stayed on a gradual rate raising trajectory has been the slow response of labor compensation to tightening labor markets, and the March employment report does little to change that thinking.
With average hourly earnings rising 0.3% and 2.7% year-over-year, wages are essentially rising fast enough, despite a disappointing 103,000 non-farm payroll rise, to keep the Fed on its current normalization path, but not so fast as to provoke more aggressive rate action at this juncture, especially given prevailing trade and financial uncertainties.
To be sure, Fed officials have spoken prospectively about wage pressures, on the premise that the Phillips Curve still has some vestigial value. Boston Federal Reserve Bank President Eric Rosengren, for example, observed last month that “with labor markets tight, some employers will attempt to attract new employees by offering higher wages and benefits, raising the average compensation paid to many employees over time.” Noting various wage measures have been “gradually trending upward over the past several years,” he added, “As the labor market continues to tighten … one would expect to see continued upward pressure on wages and salaries.”
Fed Governor Lael Brainard warned, “If the unemployment rate continues to decline on the current trajectory, it could fall to levels that have been rarely seen over the past five decades. Historically, such episodes have tended to see elevated risks of imbalances…” She conceded wage gains “continue to fall short of the pace seen before the financial crisis,” but cautioned, “we do not have extensive experience with an economy at very low unemployment rates and cannot be sure how it might evolve.”
There has been some improvement in wages, but not nearly as dramatic as once would have been expected in wake of the six percentage point drop in the unemployment rate that has occurred since the recession. The Fed’s most recent beige book survey found wage gains to be “moderate” throughout its 12 districts.
March’s year-over-year rise in average hourly earnings is slightly better than in February and a good bit better than a couple of years ago, but it was down from 2.9% in January.
The employment cost index has been rising as well, but at a creep — from 2.4% in the second quarter of last year, to 2.5% in the third quarter to 2.6% in the fourth quarter. Hourly compensation from the productivity report rose to 2.9% year over year in the fourth quarter.
The wage and salary component of personal income has risen an average of 0.525% per month over the last four months — a more encouraging pace indeed if it can be sustained.
But wages are still rising much less than in the two years prior to the crisis, when they averaged 4% or higher. And there are few indications wages are on the verge of a significant escalation. In a March survey, the National Association for Business Econommics said 51% of its members foresaw “no change” in their outlook for wage gains in 2018, while 42% “had raised their projections modestly for labor compensation in 2018.”
The widely blamed culprit for sub par wage gains is the slowdown in productivity growth to 0.5% per year from 2.5% before the financial crisis.
As Fed Chairman Jerome Powell observed after the Federal Open Market Committee raised the federal funds rate on March 21, “what wages should in theory represent is inflation plus productivity increases. You should get paid for your productivity plus inflation, and productivity’s been very low. Inflation’s been low. So, these low wage increases, in a sense, they do make sense … from that perspective.”
“(L)abor markets have tightened, and we hear reports of labor shortages … and the unemployment rate is going down,” Powell continued. Yet, “we haven’t seen … wages going up more. And ….I’ve been surprised by that, and I think others have as well…. I think we will know that the labor market is getting tight when we do see a more meaningful upward move in wages.”
Atlanta Fed President Raphael Bostic, a voting member of the FOMC, says that in his district “many businesses are facing some pressure on labor costs, often in the form of nonwage expenses. Still, these costs do not yet seem to be accelerating, and my belief is that labor market conditions are not yet overheated.”
You have to give the Fed credit for being consistent. The factor it blames for restraining wage inflation — weak productivity — is the same factor it cites in lowering estimates of the economy’s growth potential and the longer run “neutral” funds rate.
If tax-incentivized business investment boosts productivity, as Powell and others postulate, we could end up with higher wages but not necessarily more inflation because the economy’s capacity to grow and create jobs in a noninflationary way will have increased. But there may be a long way to go before that point is reached.