The surge in US wage growth

The US has been in the Late Upswing stage of the business cycle since 2016, characterised by full employment, rising inflation pressures, growing financial fragility and a vigilant Fed. But until 2018 there wasn’t much sign of the rising inflation pressure. Until last year when wages surged, whether measured by hourly earnings or the employment cost index.

There shouldn’t be any surprise about this really. The two factors which drive wages are the level of unemployment and the rate of growth of the economy. Unemployment, however measured, is low now and the economy was booming at an above 3% rate for several quarters. The reason the Fed could afford to ignore this and go on hold boils down to two reasons. First, the stocks volatility made them wonder whether they had already done enough to slow the economy, perhaps even cause a recession, so didn’t want to overdo it. Secondly, while wage growth has accelerated, at 2.5-3% it is still well below levels seen in the last two upswings when it reached 4% or more.

Of course, the rate of wage growth consistent with the 2% inflation target also depends on the rate of productivity growth which has been disappointing for the last decade. If productivity growth averages only 1% then 3% wage growth would be the limit. In fact output per hour growth has been nearer 0.75% pa in recent years. Still, there are hopes that productivity could pick up this year and next, especially given the strong investment at the moment, so the Fed is inclined to give it the benefit of the doubt.

The Fed then is on hold, but watching closely to see where wage growth and the economy go from here. I am pretty confident that we are not facing a recession (yet) but more likely growth close to or just above trend (around 2%). The slowdown will help ease some labour market pressures and unemployment has already ticked up slightly but is unlikely to rise much more. If it did, that would indicate a recession. Trade policy will matter too because if companies are shielded from foreign competition there is a greater chance they will raise wages.

My expectation is that wage growth will continue to accelerate over the next year, though probably at a slower pace than in 2018. But I expect productivity growth to pick up a bit too, helping to keep the Fed on hold for most of this year. Staying on hold will be easier if GDP tracks about the 2% rate I expect so that unemployment is fairly stable. But I still think the next move for the Fed will be up, before this upswing is over. That said, even when the Fed starts tightening again, I expect them to go cautiously. The market correction in Q4 was triggered by a combination of a hawkish Fed, a protectionist President, and slowdowns in China and Europe. The Fed will not want to be blamed for the next recession unless it is clear that inflation has moved up to levels which justify a hawkish stance.