Wages, Inflation and a Fed Pause

  • The new boogeyman on Wall Street is the sharp decline in manufacturing PMIs in China and the U.S. The U.S. economy is at full-capacity, there was never going to be an extended period of 3% growth.  A slowdown in manufacturing growth was necessary and unavoidable.

  • If inflation expectations are rising and the stock market is falling expect Powell to move against expectations to the woe of Wall Street.  Powell has made it quite clear that he is a true-believer in the Fed’s mission. 

  • I will be watching indicators of the household sector’s medium-term inflation expectations, which are influenced by large moves in high-frequency purchases such as gasoline and food.    

Capacity in the U.S. labor market is tight and wage growth is accelerating rapidly across industries.  I have been writing for three years now that the Phillips Curve is a curveand that once labor resources became scarce wage growth would accelerate non-linearly (i.e. the third derivative becomes positive).  That now appears to be happening as the Atlanta Fed’s Wage Growth Tracker has accelerated for four months without any decline in the Non-Employment Index (Chart 1).  As I’ve discussed in prior notes, the lag between hiring and wage growth is about nine months.  Using November data, the most recent available, current wage growth is being influenced by labor market conditions in February 2018 (Chart 2).  Note that there are five more months of labor market tightening in the pipeline, which implies wage pressure will have significant momentum even if the overall economy slows down.  

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Wage pressure is evident across the economy, particularly the nearly-vertical wage acceleration happening in the service-providing industries [1].  This acceleration, although it took a long time to happen, is exactly what one would expect to see in a “normal” recovery (Chart 3).  Indeed, the sudden burst in hiring plans by the small business sector that began in 2017 was soon followed by wage growth acceleration in services (Chart 4).  Small businesses tend to operate in service-providing industries and add productive capacity by hiring workers rather than installing new capital goods. Once sentiment in this sector moved into strong expansion territory the full weight of business demand for labor resources was brought to bear.

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The service-providing side of the economy has about 150bps of acceleration to go before wage growth reaches a historically normal rate of 4.5%, but the goods-producing sectors are already there (Chart 5).  The two sides of the economy are vying for scarce workers, so service-providing wage growth will need to catch up.  Given the remaining supply of available labor (i.e. little or none), growth of 200,000 jobs per month is clearly highly inflationary for wages (Chart 6).  Either demand for labor needs to cool or wage growth will continue to accelerate at an accelerating rate.

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A variety of indicators are flashing warning signs that the labor market cannot provide the resources demanded by businesses at any price.  Chart 7 shows average wage growth for the current Top 20 wage-growth industries.  Note the dramatic acceleration that began in late 2017.  These sectors are bottlenecks where companies are willing (and able) to boost wages by ten percent or more to meet customer demand. 

The number of industries experiencing spikes in wage growth will expand as the U.S. economy hits an increasing number of bottlenecks.

Chart 8 shows the Atlanta Fed Wage Tracker for full- and part-time workers.  Note the late-stage acceleration that took place leading up to the previous two recessions.   After many quarters of expansion, with no spare labor available, businesses try to entice voluntarily part-time workers to put in more hours by bidding up their wages. Obviously, the increase in part-time wages did not causethe recessions of 2001 and 2007-2009.  Acceleration of this class of wages indicates how much pressure is built up in the labor market.  Paying higher wages squeezes margins and, if it continues, eventually becomes inflationary. Perhaps this measure should best be viewed as an indication of the amount of pressure on the FOMC to switch to a “tight” monetary position.  That of course will end the boom and rapidly swing the economy into liquidation.

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The new boogeyman on Wall Street is the sharp decline in manufacturing PMIs in China and the U.S. Talk of “globally synchronized growth” has faded and concerns about recession have resurfaced.  

It really should not come as a surprise that consumption in China is disappointing expectations because the much-promised transformation of China into a consumer-led economy never happened (Chart 9).  The Trump tariffs are clearly having a disruptive effect on manufacturing in the U.S. as key components made in China are either not available or can only be found at a premium.  However, I think this angle is being overplayed in the commentariat.    

The U.S. economy is at full-capacity, there was never going to be an extended period of 3% growth.  A slowdown in manufacturing growthwas necessary and unavoidable.  Manufacturing growth in the U.S. will likely decelerate further to eventually meet with potential growth.  However, unlike China, the U.S. economy is diversified and largely non-tradable.  As a result, the deceleration in manufacturing growth is being compensated for by an acceleration in non-manufacturing activity (Chart 10).  I do not take the disappointing ISM data for December as pre-warning of a severe slowdown in the U.S.

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Even if we do assume that a sharp slowdown in manufacturing in the U.S. will occur and will lead to overall labor market weakness, that does not mean that wage growth (or inflation) will suddenly decelerate in-step with the economy.  Chart 11 below shows the strength in “temp” employee placement, which is a leading indicator of overall job market conditions.  Even a sudden turn at the margin of the white-collar labor market (i.e. employees paid per diem) will take 6-12 months to flow into a downturn in overallemployment.  And, as discussed above, there would be another lag between weakening overall conditions and weakening wage growth.  Investors should expect wage growth to continue accelerating even when the labor market begins to soften.

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Conclusion

Of course, discussions about Philips Curves, productivity growth and inflation are an academic proxy for what really matters for the FOMC – inflation expectations. The committee places immense importance on “well-anchored” inflation expectations.  It is no wonder, because without stable inflation expectations the FOMC has no reliable way to influence real interest rates.  As a market commentator or an investor JeromePowell probably would call for a “pause”, or at least some soothing words.  But where you stand depends on where you sit.   

Chairman owell, is the sixteenth chairman of an organization legally mandated to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”  As discussed in my previously referenced note in the Fed, Powell has made it quite clear that he is a true-believer in the Fed’s mission.  Indeed, he has publicly said (although not in so many words) that he would resist political influence over the Fed.  I would not test his dedication to the Fed’s mandate by expecting Powell to blink just because the stock market goes down.

I will be closely watching indicators of medium-term inflation expectations, such as the University of Michigan Consumer Expectations survey.  These expectations are heavily influenced by high-frequency purchases such as gasoline and food.  Chart 12 below shows that the oil price crash of 2014 significantly depressed consumer inflation expectations.  This gives the FOMC room, even some cause, to let the economy run above potential growth for a period.  However, the problem is no one knows, when, if, or how fast price expectations will rise if wage growth accelerates sharply.  If inflation expectations are rising and the stock market is falling expect Powell to move against expectations to the woe of Wall Street.  

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[1] Note that “services-providing” includes all non-goods producing industries rather than “service occupations” which is the narrower definition dominated by Leisure and Hospitality.