One of the conundrums of the current economic expansion in the United States has been the tepid wage growth evident in the recovery thus far. Although wage growth has picked up somewhat over the past year, it remains in a band between 2.5% and 3% and below the levels of wage growth seen prior to the last recession in 2007. This conundrum is all the more perplexing, given that the official unemployment rate has continued to decline to a new cycle low of 4.4%.
This is the lowest unemployment rate since May 2007, continuing the downward trend in unemployment from a high of 10% in October 2009. Prior to the Tech Bubble bursting, US unemployment declined briefly below 4% in 2000 and touched 3.8% in April. Before that, we would have to go back as far as the late 1960s to encounter a sustained unemployment rate of below 4%. For all intents and purposes, the US is currently at, or very close to, full employment.
As discussed in a prior article, some of the continued suppression of wage growth may be as a result of secular demographic trends, such as the growth in retiring baby boomers that are increasingly being replaced by millennials with lower wage packages. Even at full employment, this dynamic would tend to suppress overall wage growth.
Nevertheless, despite the still subdued level of overall wage growth, unit labour cost inflation has remained elevated. The chart below shows how unit labour cost inflation, namely the increase in wages after taking into account the growth in output per worker (productivity), has remained consistently positive between 2% and 3% over the past five years.
This dynamic reflects the low productivity growth we have seen during the current economic expansion. In essence economic growth has been below what economists would have expected based on prior economic expansions and given the very robust growth in total employment. This is important as wage growth on its own is not inflationary if accompanied by strong productivity growth. Hence, unit labour cost inflation AFTER taking into account productivity is a more important indication of potential inflationary pressures.
If we focus on unit labour cost inflation, specifically the growth in this metric on a 3-year basis, the graph below reflects that US unit labour cost inflation is at the highest level since the early 1990s. This is with the exception of the 2007/8 period when large job losses temporarily and artificially boosted the metric.
Why has productivity in the US been so low?
There are many reasons that have been cited for the recent level of low productivity, including a lack of new capital investment by the corporate sector. Furthermore, the same demographic force that has suppressed nominal wage growth may also be a factor suppressing productivity growth. Essentially new millennials entering the workforce or taking over the same jobs from retiring baby boomers will take a bit of time and on the job training to reach the same level of productivity (this is especially true for technical or manufacturing industries).
Alternatively, with the workforce ageing and thus not adapting to new technologies and work processes, output per worker has slowed. This is more likely the case in the services industries, where knowledge of the latest technology and associated work processes is more important than technical experience.
We have no conclusive way of knowing which factor has been the dominant reason for the recent period of low productivity growth. It could also just be that the sectors of the economy that have accounted for much of the job gains over the past five years have a higher job intensity relative to the output value, such as hospitality, when compared to prior economic expansions.
What we can say conclusively is that the Federal Reserve has an inflation mandate and not a wage growth mandate. In the final analysis, whether wage growth accelerates or not from current levels, is not that important for future inflation and monetary policy. What is more important will be the trend in unit labour cost inflation. Right now, this trend is sending a clear warning signal to policymakers that future inflation risks are rising.
In fact, if we compared current unit labour cost inflation relative to prevailing shorter-term interest rates in the US, we can see that monetary policy and theoretically real interest rates, remain very accommodative. The differential between unit labour cost inflation and the prevailing two-year yield at present is close to the widest levels since the early 1980s and 1970s, which was a period of high inflation and low economic growth.
This backdrop suggests that any sudden and unexpected acceleration in US wage growth and core inflation would leave the Federal Reserve well behind the curve. Alternatively, if businesses lack pricing power, then the increase in unit labour costs may not necessarily feed through in a meaningful way into headline inflation. Indeed, this seems to have been the case thus far this year, with US core inflation easing back somewhat since reaching a cyclical peak around 2.3% y/y.
However, if unit labour cost inflation remains elevated, there will inevitably be consequences. Either businesses will raise their selling prices, leading to a renewed acceleration in inflation or they will have to absorb these costs increases which will lead to an erosion in profit margins.