Economics: Time to ignore wage growth

| May 3, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

For several years during the current expansion, average hourly earnings seemed to get the most attention in monthly employment reports.  The labor market was getting tight in 2015 and 2016, but Chair Yellen made it clear she would not believe it until she saw wages begin to accelerate rapidly.  Wage gains did finally pick up in earnest in 2017 and 2018, but the gains have not translated in a clear way to price inflation.  As a result, the Fed has spent far less time this year thinking and talking about wages.  As the evidence of a rise in trend productivity growth accumulates, the de-emphasis on wage gains may be fortuitous, as the implications of faster wage growth may become even foggier.

Fed confusion

The Federal Reserve has always been a big believer in the primacy of the labor market as a driver of inflation.  The narrative is that when labor markets become tight, firms are forced to hike pay to retain and attract workers, which raises their costs and leads them to at least attempt to pass through higher prices to their customers.

The FOMC in its statements from 2012 to 2014, set out a 6½% unemployment rate as a minimum condition for moving off of the zero bound.  As it turns out, the unemployment rate fell much more rapidly than officials expected, and the Fed was forced to amend its language when the unemployment rate hit that threshold before officials were ready to hike rates.

In particular, in the early years of Janet Yellen’s tenure as Fed Chair, the unemployment rate fell to levels that were considered by most as evidence of emerging tightness in the labor market, but wage rates were failing to respond.  Yellen took this as a signal that there was hidden slack in the labor market.  As a result, the Fed began to downplay vigorous payroll growth and the inexorable decline in the jobless rate.  The mantra at the time was that until wages begin to accelerate, the labor market must be looser than it might have looked at first glance.  This made the wage data among the most important indicators for financial markets and others trying to follow the Fed’s thinking.

Wage increases did finally begin to pick up, gradually in 2016 and 2017, and then more forcefully last year.  The upswing in wages undoubtedly played a role in pressing the FOMC to ratchet up the pace of policy normalization in 2017 and 2018.  However, when the long-awaited surge in wages in 2018 failed to push the inflation rate above 2%, Fed officials and staff began to scratch their heads.

Chairman Powell is much less invested in models than his macroeconomist predecessors, and his Jackson Hole speech last summer basically took the stance that there is so much uncertainty regarding the key guideposts in the Fed’s models (unobservable variables like the equilibrium rate of unemployment and the neutral real interest rate) that the Fed would just have to grope around like someone trying to navigate in a dark house while avoiding the furniture.

In any case, ironically, when the Fed finally got the considerable wage hikes that it had been waiting so long to see, it stopped paying attention, as policymakers and staffers decided that the link between the real economy and labor markets on one side and inflation on the other had been attenuated, if not severed (the “Phillips Curve is dead” theme).

Productivity shifting

Most economic models, including those used at the Fed, are focused almost exclusively on the demand side of the economy.  The supply side of the economy is broadly taken as given, though occasional adjustments can be made to the models if the data warrant.

Historically, this has proven problematic at times for the Fed.  Economists and policymakers were blindsided by the productivity slowdown of the 1970s, which led the Fed to strive for unattainably high growth and unattainably low unemployment for years, ultimately resulting in the Great Inflation of the 1970s and early 1980s.  Conversely, when productivity growth accelerated in the 1990s, those most closely following the Fed’s models were arguing for steeper rate hikes, but Chairman Greenspan, who was not as big a believer in standard macro models, sniffed out the emerging changes and convinced the FOMC to limit their policy rate hikes.

More recently, at the beginning of the decade, the FOMC pegged potential GDP growth in the high 2%’s, implying trend productivity growth of around 2%.  However, beginning in 2011, productivity growth slowed sharply, averaging 0.6% over the 2011-2016 span.  It took that entire six years for the FOMC to bring its median estimate of potential GDP growth down to 1.8% (where it remains today), though, thankfully, unlike the 1970s, inflation failed to take off.

As it turns out, when the FOMC finally got to something close to the “right“ number for potential growth (indirectly acknowledging that trend productivity growth had slipped to about 1%), productivity growth began to re-accelerate.  Productivity growth picked up to 1.7% last year (and the Q1 2019 was a stellar 3.6%).

However, Fed models are not going to fully incorporate this shift for a long time.  Most Fed officials have taken the same stance as the consensus of economists, leaning on their demand-side models to explain the impact of the 2017 tax reform.  The prevailing story is that the 2017 tax reform was a standard-issue Keynesian demand-side stimulus that merely provided a brief sugar high in 2018 that has long since dissipated.  However, this is a poor framework for assessing the recent tax reform, which mainly impacted the economy by improving the incentives for business investment, not by temporarily inflating consumer spending.

In any case, faster investment spending since 2017 is translating, just as logic would dictate and economic theory should suggest, into faster productivity gains, as workers benefit from having better equipment to use and more efficient physical plants to operate in.  The underlying trend in productivity has probably already accelerated, perhaps to 1½% or higher, though past experience tells us that it may take the Fed three to five years to fully take this shift on board in its economic models and projections.

Bringing it back to wages

If the trend of productivity growth is in play, then the implications of shifts in wage growth become ambiguous.  A pickup in wage gains could be caused by tightening in the labor market, as firms are forced to bid up the price of increasingly scarce labor supply.  Or, alternatively, firms may be paying higher wages because workers are becoming more productive at a faster clip.  The former scenario is, at least in theory, inflationary, while the latter scenario is most certainly not.  The reality in the current environment is likely to be some of both, but there will be no way to precisely distinguish between the two.

As a result, even if Fed officials were so inclined, it would not make sense for them to rely on the trends in wage gains to provide a leading indicator of the inflation outlook.  Most Fed policymakers and staffers have seemingly thrown their hands in the air and discarded their models in a fit of pique without understanding why the models are not working the way they should.  An acceleration in productivity might help to explain the lack of a link between wage gains and price inflation right now, and I would expect the Fed to bring that explanation on board — by sometime in the first half of the next decade.  Until then, we may see a lot of Chairman Powell and company groping around in the dark, just hoping not to bump into the furniture.

john.killian@santander.us 1 (646) 776-7714

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