The mystery behind sluggish wage gains
The Phillips curve is dead. Long live the Phillips curve.
THE REAL ECONOMY |
When the economy picks up, businesses look to hire more workers. As demand for workers increases, businesses begin offering higher wages to compete for a dwindling supply of labor. Pretty straightforward, right? This seemingly intuitive link between employment gains and an increase in wages is an economics observation known as the Phillips curve model.
Central banks use the Phillips curve as an input when setting monetary policy. There have been periods when the Phillips curve appeared to be an appropriate framework for observing the relationship between employment and wage inflation. But recently, the lack of a more significant pickup in wages as unemployment heads toward our forecast of 3.5 percent has been one of the major dilemmas facing policymakers and economists. “The Phillips curve is dead,” some have said. After all, the risk around using the Phillips curve as a policymaking input amid sluggish wage gains is that the Federal Reserve may increase rates too quickly, thus stifling the economy.
The Phillips curve model is traditionally presented as a scattergram, with wage growth on the Y-axis and the unemployment rate on the X-axis. From 1988 to 2002, the period after the effects of the oil crisis and stagflation were wrung out of the economy (and before the housing bubble became a full-blown crisis), the intuitive relationship between monthly private-industry wage growth and the unemployment rate appeared to be largely intact over the course of a business cycle.
But more recently, the relationship between monthly private wage growth and the unemployment rate has been somewhat unstable. Since 2010, the improvement in employment in the wake of the Great Recession has been constant, with unemployment dropping to 3.7 percent in October 2018 from 9.9 percent in April 2010. But wage growth over that eight-year period has been lagging, suggesting externalities (the development of the global supply chain and the infinite supply of labor) or structural shifts such as the impact of automation on the availability of low-wage manufacturing employment were at work.
For middle market businesses, this is less about a policy choice and more about managing their labor costs. After all, if the Phillips curve relationship remains unstable, then businesses may be able to turn to alternative benefits packages or employment attraction strategies to increase their headcounts. But if the Phillips curve model is instead on the verge of describing a more traditional relationship between tight labor supply and wages, then their labor costs may be about to rise … significantly.
October data says, “Not so fast”
The October U.S. jobs report showed a 3.1 percent gain in average hourly earnings on a year-ago basis—the strongest monthly showing since April 2009. Meanwhile, on a three-month average annualized pace, average hourly earnings increased 3.6 percent, a sign that wage pressures are starting to flow through the economy. This suggests a more stable relationship developing between labor supply and wages.
Meanwhile, the policy implications of the October jobs report are clear. The results reaffirm the growing hawkishness of the Fed, which will increase the federal funds rate by 25 basis points in December and is poised to increase the main policy rate by at least 75 basis points in 2019.
Given the Fed’s use of the Phillips curve, it is likely going to interpret this most-recent data, if it’s sustained, as modestly inflationary. The RSM view is that there is some risk the Fed increases the pace of its rate increases and hikes the policy rate by 100 basis points next year. Long live the Phillips curve.
The benefits of low unemployment may be offset by ongoing wage stagnation and a rising number of low-skilled workers who are left behind.