As the U.S. Federal Reserve Board sticks to its dogged path of monetary easing, investors are sleuthing for inflation scenarios, and believe they have stumbled onto one: a wage-driven inflation spiral.
But is an inflation surge of this (or any) kind really, well, elementary?
Inflation worries seem everywhere. Bond yields are up sharply, and, more worryingly, the yield curve is steepening, implying inflation will not come alongside economic growth. In other words, the market is predicting an infamous stagflation scenario is about to unfold. The equity markets are signalling a similar cautious sentiment as price leadership is no longer being driving by transports, the usual bellwether for economic growth.
In zeroing in on an inflation scenario, investors appear to have eliminated most of the plausible suspects. Commodity prices, particularly energy, have stagnated, thanks to weak economies in Asia and the surge in U.S. oil and gas production. The U.S. dollar, while down by 25 per cent in price-adjusted terms over the past decade, has resulted in no meaningful inflationary pass-through to consumer prices to date. Moreover, the broad U.S. dollar index is up almost 20 per cent since mid-2011. Inflation expectations also remain extraordinarily contained according to both survey- and market-based measures.
Having eliminated the most plausible inflation scenarios, investors have turned to the implausible: labour market pressures causing a wage-driven price spiral. It has been so long since the U.S. economy experienced a wage-price spiral – one has to dig back in history books to the 1970s – that it has become mythical and legendary in status. And with the legend have come some very loose, shorthand facts revolving around the cause and effect of the series of energy shocks in that decade.
Since the 1970s, many papers have been written questioning this shorthand-thinking about what caused the U.S. economy to slip into stagflation in that decade. Some of the research was conducted by Fed chairman Ben Bernanke when he first became a governor at the Fed a decade ago. Indeed, many academics now argue the 1970s stagflation episode was the result of easy monetary policy in the 1960s.
In part, the 1960s easy policy was driven by extraordinary labour market strife at the time. In the first half of the decade, real wage gains were sluggish at barely 1.7 per cent a year, while corporate profit margins were at a then-historic peak. Starting in 1965, work stoppages due to strikes became rampant and reached a crescendo in 1970s, with stoppages amounting to 29 per cent of work time and 250,000 workers on strike per year. With the stoppages severely affecting revenues, corporations gave in to wage demands and passed the higher costs along to consumers – and the wage-price spiral was on.
Now is a good time to slow down our thinking, collar another bloodhound or two, and keep scouting the monetary moors for the real culprit.
That the Fed is repeating the mistakes of the 1960s and 1970s makes a compelling case until one simple fact comes to light: the U.S. worker currently has no labour market power. In the 1960s, unions were king; Jimmy Hoffa's Teamsters union alone claimed 1.5 million members, or almost 10 per cent of the 17 million unionized workers in the United States. In the 1960s, three out of every 10 employees possessed a union card.
What a difference two generations of workers makes. Today, only one in 10 employees is a union member. American workers not only compete for jobs with their next-door neighbour, but with a world of low-wage workers as well. Worker strikes are infrequent and rarely last more than a few weeks.
The Great Recession has also taken a toll on worker power, with the U.S. unemployment rate still well above 7 per cent, youth unemployment topping 16 per cent, and surveys showing 40 per cent of recent university grads are more likely to require a paper hat for their new job than a sheepskin.
Not surprisingly, then, compensation metrics remain benign. What matters most for a wage-price spiral to take hold is for wages to rise faster than the rate of productivity growth – a.k.a. unit labour costs. These data continue to show weak trends, with the yearly pace at just 0.6 per cent in the latest reading, and wage growth partly offset by continued productivity growth.
In Canada, some of the same structural forces help keep wage and price pressures in check, but not all. Canadian workers also must compete with less-expensive workers abroad as demand for lower-cost imported goods persists. Unionization rates in Canada are slightly higher than in the United States, in part due to a higher proportion of government workers on this side of the border, but are also down precipitously from the heydays of the 1960s.
However, one structural factor remains elusive in Canada – productivity growth. In the past five years, labour productivity growth has averaged a paltry 0.4 per cent a year. As a result, unit labour costs have risen an average of 2.1 per cent annually over that period – and currently reside at a worrisome cycle high of 3.7 per cent. To be sure, Canadian businesses have similar fat profit margins to absorb these higher labour costs, but the risk remains that some of those costs start to show up in higher consumer price inflation in the not-too-distant future.
This factor alone suggests the short end of the Canada curve should be commanding a higher premium to U.S. Treasuries – and pricing in at least some probability the Bank of Canada will raise rates before the Fed over the next two years.
Sheryl King is an independent macroeconomic strategist with more than 20 years experience in the international financial industry and central banking.