An analysis by Josh Bivens at the Center on Budget and Policy Priorities looks at the connection between wages and inflation. The strong link between interest rates and price inflation is through the mechanism of wage increases which are spurred by tightness in the labor market. By increasing short-term interest rates, the pace of economic activity is lowered, reducing the pace of declines in unemployment which reduces the ability of workers' to bargain for higher wages which, in turn, reduces the pressure on inflation. Mr. Bivens observes that, since wage inflation and not slackness in the labor market is the most significant intermediate link between interest rate increases and lower price inflation, the brilliant minds at the Federal Reserve should focus on wage inflation as an indicator of where interest rates should head. With the Federal Reserve contemplating a move toward tightening after their prolonged experiment with zero interest rates because of improvements in the headline unemployment rate, perhaps they need to take a closer look at what has happened to nominal wages to determine their future policies.
As has become apparent, the traditional measures of economic health, particularly the headline U-3 unemployment rate have become particularly useless indicator of economic health since the labor force participation rate, at 62.5 percent, is depressed to levels not seen since the late 1970s as shown on this graph:
Other economic measures like estimates of the natural rate of unemployment which is the rate below which inflationary pressures will increase are subject to large margins of error and are not suitable for determining monetary policies.
As we've noted, since late 2010, the unemployment rate has fallen steadily yet, inflation has remained tame as shown on this graph:
This is telling us that even though unemployment dropped from 10 percent in 2010 to approximately 5.5. percent in mid-2015, inflation has not reared its ugly, frightening (to central bankers) head. Conventional wisdom would tell us that inflation should be much higher than it is given that unemployment has nearly halved and that there should be significant upward pressure on wages. Unfortunately for those of us who work for a living, this graph that shows what has happened to nominal wages and unemployment since 2006 is particularly sobering:
Economists like to use the Phillips curve which plots the percentage change in inflation (or nominal wages since the two are closely connected to each other) against the level of unemployment which looks like this for the 1960s:
As you can see, at high levels of unemployment, inflation/wage increases are low. In the 1960s, as the economy moved from 6.5 percent unemployment to 5.5 percent unemployment, inflation/wages rose by a less than one-half percent. When the economy moved from 4 percent unemployment to 3.5 percent unemployment, inflation/wages rose by more than a percent. As unemployment decreases, inflation/wage increases begin to rise at a faster rate. This is not the case now; as the graph above shows, at 5.5 percent unemployment, the inflation rate/rate of nominal average wage increases is far, far lower than most economists would predict using the Phillips curve.
Now, let's switch gears and look at another measure of economic health, productivity, a measure that will help us set a wage target. First, here's a rule of thumb from the paper:
"...as long as nominal wages are growing at or beneath the rate of productivity growth, then labor costs are putting no upward pressure on prices at all. This concept is embodied in unit labor costs, i.e., the unit of compensation per unit of productivity. If real wages and productivity accelerate by equal amounts (in percentage terms), there is no increase in unit labor costs and no pressure on prices from wage growth, as more efficient production (faster productivity growth) has “absorbed” the wage increase such that it does not need to be passed through to prices.
For small magnitudes, the change in unit labor costs can be approximated as the percentage change in hourly pay minus the percentage change in productivity. And this change is what the Fed is hoping to keep running below its target rate of overall price inflation. So long as unit labor costs are rising at less than 2 percent, they are not putting upward pressure on the price inflation target."
Obviously, changes in worker compensation are closely connected to the growth rate of productivity. Here is a graph showing the total growth in net economy-wide average annual changes in productivity over 12, 24 and 60 month-long cycles between 1995 and 2014:
Productivity growth over the cycle between 2001 and 2007 averaged 2.1 percent and over the four cycles between 1973 and 2007, it averaged 1.5 percent. The author feels that range of 1.5 to 2.0 percent is reasonable. Therefore, if we sum changes in productivity at 1.5 percent to 2.0 percent and accompany it with inflation at 2.0 percent (the Federal Reserve's target rate), then hourly compensation growth of between 3.5 and 4.0 percent should not cause a problem. That said, as shown on this graph, the year-over-year change in nominal average hourly earnings of American workers since 2007 has been well below the minimum wage-growth target (shaded grey):
As you can see, hourly wage growth has been between 1.5 and 2.5 percent since 2009, well below the wage-growth target. This extremely low level of wage growth makes us wonder why inflation hasn't been even lower than it is. Here's the fly in the ointment:
All of the growth in prices since the second quarter of 2009 can be accounted for by rising profits (light blue bars) due to increases in markups over costs. Unit labor costs have been flat and all other costs have actually declined but unit profits on a pre-tax basis have increased by 7.6 percent annually. This growth in unit profits are responsible for 64 percent of the rise in prices since the last business cycle peak in the last quarter of 2007.
This is why the labor share of corporate sector income has done this since the early 1980s:
With nominal wage growth of 4 percent, it would take until 2029 to attain the pre-Great Recession labor share of corporate sector income of 79.4 percent in Q4 2007. Using the same 2 percent inflation numbers and 1.5 percent trend productivity growth as before, with nominal wage growth of 4.5 percent, it will take until 2022 and with 5 percent nominal wage growth, it will take until 2019 to attain the pre-Great Recession labor share of profits as shown on this graphic:
Despite the fact that we are now seven years past the trough of the Great Recession, we are still seeing very little improvement in the wages of American workers. Wages are still growing at levels that are well below the non-inflationary wage-growth target levels of between 3.5 and 4.0 percent. Rather than sharing the benefits gleaned from increasing worker productivity since the Great Recession, Corporate America is choosing to pad its bottom line, explaining why inflationary pressures have been far lower than we would normally expect.