Should financial markets start worrying about wage inflation? Some recent research out of the U.S. Federal Reserve suggests the debate is heating up, and it could well spill from the Ivory Towers into the Street in the not-too-distant future. The current hot topic for wage inflation is whether the Fed policy should go short or long, when it comes to the duration of unemployment.
It has been a long time since investors have needed to focus on wage measures, such as former Fed chairman Alan Greenspan’s favourite, the employment cost index (ECI). The ECI has not edged above 2 per cent yearly growth in more than two years. Average hourly earnings and unit labour costs tell a similar story: Wage pressures are muted.
However, muted wage pressures today are not a guaranteed to stay that way in the future. Many indicators suggest the U.S. labour market is returning to full health. The unemployment rate has dropped by almost a full percentage point in the past year. The average hours worked per week are just below the pre-recession high – and the average workweek of manufacturing workers is the highest since the Second World War. Clearly, the demand for labour in the U.S. is becoming brisk; upward pressure on wages may soon follow.
With these trends in mind, the debate about wage inflation is heating up at the Fed, with most of the recent debate centred on how to measure labour market tightness.
In recent years, the popular belief has been that conventional measures of unemployment vastly understate weakness in the labour market and, hence, misstate wage pressures. Analysts cite discouraged workers, high levels of part-time workers and long-term unemployment as explanations for why wage pressures have been so muted since the Great Recession of 2008-09.
But a study published this month by staffers at the New York Federal Reserve Bank called this popular narrative into question. The paper, entitled “The Long and Short of It: The Impact of Unemployment Duration on Compensation Growth,” notes that even the conventional measure of the unemployment rate has underpredicted wage growth since 2008 – a sign there is less slack in the labour market than most analysts believe, not more.
The report’s authors found that measures of short-term unemployed (less than 27 weeks) have done a better job at explaining wage growth patterns over the past five years than the conventional unemployment rate. Notably, the authors’ estimate of the gap between the short-term unemployment rate and the longer-run trend suggests that there is currently no labour market slack in the U.S. economy – an unsettling observation, considering how low U.S. bond yields are at present.
The issue of labour market tightness and its implication for wage inflation is far from settled within the Federal Reserve system. Indeed, the Boston Fed published a paper last year, using micro-data, that suggested that the long-term unemployed take 20 years to re-attain the wage rates they commanded before becoming unemployed.
Clearly, long-term and short-term unemployment camps are starting to form within the Fed.
While recent Fed research on what drives labour costs is welcome, there is no doubt the Fed’s re-education on the matter of recent wage and employment dynamics is in its infancy. The most comprehensive Fed research on wages was authored more than 20 years ago, and the issue has fallen to the bottom of the research agenda. Since that time, there has been precious little computing time spent in understanding how labour markets have changed with the forces of globalization, outsourcing and technological change, not to mention the rapid aging of the labour force.
Even this most recent debate within the Fed, while useful, draws no conclusions about the implications for consumer price inflation if labour costs do rise. This is a point former Fed governor Donald Kohn lamented eight years ago in a speech where he laid out a laundry list of needed research into current inflation dynamics. His main message was that researchers had become too complacent, assuming that central bank credibility was now the most important driver of inflation and that all other cost pressures could be confidently ignored.
The implication is that the Fed may lack a clear understanding of current wage and price dynamics right up until the point that labour cost pressure truly rears its head. At that point, inflation expectations may start to rise as well – and the wage-price spiral may slip out of policy makers’ control.
Sheryl King is an independent macroeconomic strategist with more than 20 years experience in the international financial industry and central banking.