Wages and the Fed.

Both bulls and bears are examining wage growth for signs of incipient inflationary pressures. The current debate seems to assume that wages are completely determined by how much slack there is in the labor market and overall economy. Both conservatives and liberals seem to believe that if employment fall below current levels that wage growth must accelerate. Standard analysis seems to completely ignore the point that inflation expectations plays a significant role in the wage setting mechanisms.

I have been using a wage equation that I first developed some 20 years ago and it has worked extremely well to explain average hourly earnings growth as far back as the wage data goes, 1964. The equation has three variables, unemployment, manufacturing capacity utilization and the trailing three year change in the CPI. This is used as a proxy for inflation expectations because other measures of inflation expectations do not have a long enough consistent history. For those of you that like to duplicate work they see online, the equation does have a fourth variable that I call Nixon. It is a dummy variable for wage price controls in the early 1970s.3 yr cpi
As you can see the equation explains wages very well through the acceleration of wage growth in the 1960s and 1970 and wage moderation in the 1980s and 1990s. The only time it fails is when it called for wages to fall after the great recession. I believe this is just another example of how wages are sticky and that business had good reasons to not implement widespread wage cuts after the Great Recession.
cpi 3

The second chart shows the three year trailing CPI. At 1.3% is at the lowest level experienced since the 1950s. Moreover, it is in line with other widely quoted measures of inflation expectations. This means that low inflation expectations are offsetting some of the upward pressure on wages from the low unemployment rate and high capacity utilization. Consequently, I believe that the Fed – as well as those who have been warnings that runaway inflation is just around the corner — are overly concerned with the risk of employment gains leading to higher wages and inflation. This fed can easily leave rates at low levels with little fear that wages growth and inflation will accelerate.

Comments (32) | |