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Everybody's watching this proverbial canary in the coal mine

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By David Rosenberg and Krishen Rangasamy

Inflation watchers are interested in wages because it is the proverbial canary in the coal mine. Excessively high inflation has historically been accompanied by accelerating wage growth, over and above the trend in labour productivity.

Its true that between 1992 and 2000, wage growth picked up without a corresponding increase in actual inflation. But that was a period during which the U.S. dollar was surging, keeping import prices (and hence overall inflation) under wraps. So, could we have another wage-driven inflation spiral la late 1970s/early 1980s?

The latest data do not suggest an acceleration in the pace of nominal wage growth (and at a time when measured productivity is picking up at an even faster rate). And here we are talking not about hourly earnings data from U.S. employment reports which, as we have seen over the past year, can be distorted by composition effects as employment of lower paid workers fluctuates. Instead, were referring to the Atlanta Feds Wage Growth Tracker, which tracks reasonably well the private sector wage component of the Employment Cost Index and measures the growth of wages of the same group of workers over 12 months, making the measure less susceptible to compositional changes. According to that measure, wage growth seems to be levelling off at less than four per cent year over year.

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The loss of momentum for wages should come as no surprise considering still-significant amounts of slack in the labour market. While employment rose for the fourth consecutive month in April, there are still nearly 10 million Americans who are out of work. But looking beyond obvious cyclical factors, it is clear that structural forces continue to weigh on wages. Recall that towards the end of 2019, i.e., when the labour market was booming and the broad unemployment rate was near all-time lows, wage growth remained stuck in the three-to-four-per-cent range.

Back in 1999-2000, a similarly tight labour market generated much higher wage growth. Some will blame accelerated globalization, which moved up a gear in 2001 as China joined the World Trade Organization. Others will point to even earlier trends such as the decline in unionization rates the employment share of union members has dropped by half since 1984 which continues to limit workers bargaining power.

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The level of skills/education may also be affecting the extent of wage growth. Research from the Atlanta Fed shows that wage growth after a period of unemployment tends to be positively related with education. The same research concludes that less educated workers face a double whammy in the sense they are more likely to lose their jobs and also experience slower wage growth once they return to employment. This is exactly what the U.S. labour market is facing over the next year or so, considering most of the job losses during the pandemic were experienced by less educated employees.

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Also note that the pandemic has hurt part-timers (whose employment is down 10 per cent since February 2020) more than those with full-time positions (down less than five per cent). As such, the return to the labour market of part-timers (who also tend to earn less than full-time workers) is likely to keep a lid on overall wage growth in coming quarters.

While the outlook for wage growth is not exactly rosy, let us assume for a minute that firms suddenly feel compelled to dish out raises to workers. And here we are thinking of transformative policies by Congress to strengthen worker bargaining power e.g., increasing wage transparency, reducing the use of non-compete contracts, and reducing labour market monopsony.

Not necessarily. Historically, firms tend to pass on higher costs to consumers when wage growth outpaces productivity growth. There is indeed a clear positive correlation between the annual core inflation rate and the wage-productivity differential.

The good news is that cost-push inflation looks to be under control, with productivity growth significantly outpacing wage growth in recent quarters. It may be too early to assert with complete confidence that we are seeing a structural shift upwards in productivity, but latest data is showing a discernible breakout in trend (incredibly, to more than a four-per-cent rate at the moment).

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While we hear constantly of labour shortages in the media and survey data, the silent majority of the corporate sector has learned to produce more with less labour input during the pandemic (with business expenditure on automation rising nearly 20 per cent in the past year at a time when total labour input is down four per cent). It does look like one of the effects of the pandemic has been to push the capital-labour ratio higher and that, my friends, is not the fundamental ingredient for any sustainable inflation cycle.

Join me on Webcast with Dave on June 15, when I will be hosting Lacy Hunt, executive vice-president of Hoisington Investment Management. Learn more on my website.

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David Rosenberg: Is wage inflation getting out of control? - Financial Post