United States

Higher wages ahead

What middle market firms need to know


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The pace of economic growth and hiring accelerated during 2014, creating the conditions for modest wage growth in 2015. The U.S. output gap, or the difference between potential and real growth, has narrowed to less than 3 percent currently from a high of about 7 percent in 2009, while the number of job openings per person has dropped to a cyclical low currently of 1.82 from a high of 6.46 in 2010. Our model indicates wage and salary growth is heading toward 3 percent this year, with the risk of a higher pace of economic growth setting the stage for a breakout in wage gains to 4 percent year-over-year in 2016.

Once the data is all in, economic growth through the final three quarters of 2014 will probably come in above 4 percent. Strong manufacturing, a modest rebound in consumer demand, a fading fiscal drag, rising risk appetites and less uncertainty around the path of public policy all contributed to the improved growth and hiring picture.

For middle market firms this presents both an opportunity and a challenge. The growth picture reflects a self-sustaining turn in the pace of economic activity and will attract workers back into the labor force. This should set the stage for a banner year of growth, an increase in capital expenditures, rising productivity and hiring to meet that demand.

Middle Market Insight: Better economic growth and stronger wages will boost prospects for middle market firms, but may result in increased job churn and affect hiring policies and employee retention.

It will also result in and elevated job churn among skilled and semi skilled workers, however, and might cause firms to consider implementing policies to bolster employee retention, maintain productivity levels and reduce the substantial costs associated with worker turnover. The wage premium for employees in technology, life sciences and manufacturing industries will spill over into the consumer products sector, with areas such as food and beverages seeing increasing demand for higher wages.

Narrowing Output Gap

The economy this year is poised for above-trend growth near 3 percent and the labor market is tightening. Improvement in labor market diffusion indexes reflects a broadening of demand and prosperity. On the margin, this will begin to smooth out economic inequalities that have built up during the current business cycle. Rising job openings will result in a sustained pace of hiring near the six-month average of 263,000, which, for the first time since the end of the Great Recession, should translate to a shift in bargaining power from employers to employees and further bolster wage growth.

The Heart of the Matter

While average hourly earnings have increased only 1.7 percent on a year-ago basis, forward-looking surveys and our own wage model suggest upward movement in salaries is coming. The decline in the number of job openings per person tends to lead wage and salary growth by about two quarters. Since this is not a linear relationship, once that variable drops below 2 -- it currently stands at 1.82 -- conditions are ripe for acceleration in wage growth. In past business cycles, once wage growth has begun it typically runs for another 3.5 years near 4 percent. A recent survey of compensation plans by the National Federation of Small Businesses indicates a rise commensurate with a 3 percent increase in wages and salaries of private sector workers, which supports our own statistical research. Firms should expect wage demands to begin rising in the early year hiring season, and it will show up in the data by mid-year.

That said, the structural problems in the labor market – as defined by the number of long-term unemployed and the number of people working part-time for economic reasons -- may act as a cap on wage growth when compared with past recoveries. Average hourly earnings per worker on a year-over-year basis should stand between 4 and 4.5 percent right now based on past cycles.

Source: RSM, BLS

Optimistic Median Workers

The narrowing of the output gap and tightening in the labor market is most evident in the improvement in the “quits” rate inside the Bureau of Labor Statistics survey on Job Openings, Layoffs and Turnovers.  The three-month average in the quits among private sector industries is about 2.5 million, or 2.2 percent of all workers, both cyclical highs.

The noticeable improvement in the quits rate in the past year, along with the decline in job openings per person, should be a signal to middle market employers that workers are growing more optimistic. As a result, there will be a premium put on the retention of skilled and semi-skilled workers for the first time in this recovery. While salary increases associated with finding a new job vary from 10-20 percent, depending on the type of job, the cost for replacing workers for firms will be quite high. According to a survey of 22 research papers by the Center for American Progress, the typical cost of turnover for workers earning less than $75,000 per year, which captures 9 out of 10 workers in the economy, is 20 percent.

Middle Market Insight: With data showing workers are becoming more optimistic, expect to factor in a premium to retain skilled and semi-skilled workers.

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