Fast-growing wages may lead to higher rates

banker_558Last Friday, as on the first Friday of every month, we had the latest job report. The news is that employment is as strong and tight as it has been in years. So one would expect that wages should be going through the roof, right?

Wrong – observers have complained that wages are barely going up, and by that standard the economic recovery is weak. But this might not be true. Recent research suggests that wages are stronger than they look. If so, the Federal Reserve may have the justification they need to raise rates faster and more extensively than what the market currently assumes.

By many measures, the job market is on fire. Seven years of uninterrupted improvement after the remarkably disastrous 2008 have resulted in an almost complete recovery.

Consider the following: The non-farm payrolls number, a traditional measure of employment, has stabilized at well above 200,000 new jobs per month – higher than before the Great Recession. Initial unemployment insurance claims are fewer now than before the crisis. The unemployment rate is at 4.9%, a level consistent with full employment, and the U-6 unemployment rate, a broad measure that includes discouraged and part-time workers, is almost at pre-crisis levels. Fifteen million private sector jobs were created since the beginning of 2010, and currently they are at 122 million – the highest level ever. There are a million more job openings than at the previous 2007 peak, and workers are quitting their jobs at the fastest pace since then, which usually means that workers find it easy to get a new, better-paying job.

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In any other time, an economist looking at this data would conclude that workers can dictate their pay – an undesirable environment of accelerating wage inflation.

But this does not seem to be happening: An average of common measures of wage growth – average hourly earnings, the employment cost index, median weekly earnings, and so on – is currently running at around 2%, higher than the very weak 1.5% growth of much of the post-recession period, but well below the 3%-plus average of the last thirty years.

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A recent paper by the Federal Reserve Bank of San Francisco (FRBSF) (“What’s Up With Wage Growth?”, 3.7.2016) explains that the slow wage growth observed is mostly an illusion created by the way it is calculated. The reality, it argues, is that wages are growing just as economic theory would suggest in a strong labor market. If so, then the Fed is right to worry that wage inflation may be gathering steam.

The FRBSF explains that, by construction, wage computation over different periods does not adjust by who moves into the workforce and who moves out of it.

For example, during the Great Recession of 2008-2009 a disproportionate number of low-wage workers lost their jobs. The larger proportion of high-wage workers boosted average pay measures, and this was compounded by a sharp reduction in new hires who typically start with below-median pay. The wages of continuously employed workers rose in the early stages of labor-market improvement, keeping wage measures higher still because new job openings were few.

As the job market continued to improve, however, hiring took off and the composition of new entrants had the opposite effect on average wages. Many of the new entrants were previous part-time workers who found full-time employment; others were previously discouraged workers who were not considered until then to be part of the workforce. Others were workers who had been counted as part of the workforce but had been unemployed until recently.

These three groups entered full-time employment at overwhelmingly (80%) below-median wages, thus depressing traditional measures of wage growth. The FRBSF paper is quite precise about this, coming to these conclusions through the use of hard-core math (including references to “Daly-Hobijn percentile decompositions”, “changes in the aggregate median log-wage over a period”, etc. etc.)

The paper concludes that the wage growth of the continuously full-time employed is growing at 4% and accelerating, matching what one would expect from observed tight labor conditions. The aggregate measures suggesting that wage growth is weak are therefore misleading. The artificially low numbers are due to the unadjusted sheer number of new entrants. It is only a matter of time for those aggregate measures to show faster wage growth.

This is both good news and bad news. The good news is that the labor market is doing even better than we thought – not only growing strongly, but also delivering faster-growing pay to the continuously employed. It also raises the reasonable expectation that today’s new entrants will have higher pay as they become more seasoned.

The bad news is that this vindicates the Federal Reserve Board’s view that wage-inflation pressures are going up. While the Fed wants higher inflation, it also raises the chances that interest rate hikes could come earlier and more frequently than what the market is currently assuming, depending on what the data show in the weeks and months ahead.

Some mitigating factors come from abroad: the Chinese economy continues to appear relatively weak (exports just had the steepest drop since 2009), European prices continue to fall, and the Bank of Japan adoption of negative rates stands opposite to the stance of the US Federal Reserve.

The contrast between the US and the rest of the world seems pronounced, both on the direction of economic activity and of monetary policy. While this deserves analysis beyond the present commentary, it is fair to say that non-US considerations are likely to play a minor role in the Fed’s deliberations on when to hike rates next.

This means that the US stock market, currently buoyed by the view that rates are likely to be on hold for longer, may be unpleasantly surprised. This argues against aggressive equity positions for the time being.

What now?

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