The lack of wage growth in the U.S. labor market has been a frequent topic during our global multi-asset investment calls. Typically at this point in the economic cycle (mid-to-late cycle), wages are growing at a 4%+ pace. However, wage growth has been very modest over the past few years (2%-3% growth), puzzling many investors and frustrating many workers who have expected larger increases. This has also been a significant puzzle to the Federal Reserve, with Chair Janet Yellen calling the recent low levels of inflation (including wage growth) a “quandary.” Adding to the uncertainty in recent months has been the impact of hurricanes on U.S. economic data.
So will wages finally show some stronger upward pressure or are there structural factors at work that will continue to exert downward pressure? Below, we argue that: a) wages are growing more strongly than many realize and b) there are some compelling reasons why wage growth in this cycle has been lower than past experience.
It all depends on what you’re looking at
There are many different measures of wage inflation in the United States. Average Hourly Earnings (AHE) receives the most headlines and measures average wages per worker in the economy in one period compared with an earlier period. While easy to understand, it has a number of weaknesses including its inability to account for changes in the composition of jobs or changes in the composition of labor force. Another measure is the Employment Cost Index (ECI), which has the advantage that it holds the composition of jobs constant. It is designed to calculate the change in total cost of compensation, including not only wages and salaries (70% of index) but also benefits (30% of index). Finally, there is the Atlanta Fed Wage Tracker, which focuses on the continuously employed and therefore has bias toward older, more educated workers. It is this measure that has shown the strongest reading of wage growth over the past few years.
So, what explains the differences in wage inflation measures? Changes in the workforce due to demographics are partially at work here. New workers entering the work force (i.e., Millennials) may have lower wages than existing workers (i.e., Baby Boomers). The San Francisco Fed has done quite a bit of research on this topic and has concluded that these so called “composition effects” (the red line in the chart below) have reduced wage growth by 2% per year in recent years.
There are many other plausible theories of why wage inflation has not been stronger in recent years. These include: globalization exerting downward pressure on wages, an economy that has transitioned away from highly productive manufacturing toward lower productivity services jobs, the impact of a strengthening U.S. dollar and inflation expectations (inflation has been low, so employers and workers extrapolate this trend). We feel that all of these factors have merit, though it is difficult to measure the precise impact of each one.
Wage growth, and the broader inflation outlook in general, will be a key area of focus for us in the coming months, given its impact on the reaction function of central banks as well as risk assets. As we expect global growth to continue to broaden out, our bias is for inflation to pick up modestly. This is part of the rationale for our underweight stance to U.S. core fixed income relative to an overweight to global equities.