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Fixed-Income Insights

Wage inflation will be watched by the U.S. Federal Reserve as it weighs future tightenings. But wage growth remains sluggish, even amid a low unemployment rate.


In Brief

  • Future rate-hike decisions by the U.S. Federal Reserve (Fed) are contingent, in part, on its outlook for inflation. Wage growth will be a key factor in those expectations.
  • And yet, inflation measures have declined, as wage growth remains sluggish, even as U.S. Bureau of Labor Statistics (BLS) data show unemployment hovering around 4.4%.
  • That development has puzzled many observers, as growth in wages in salaries typically accelerates as unemployment falls.
  • What could be holding back wages? It’s not the availability of jobs, as the number of openings recently reached a record 6.2 million, according to the BLS. Further, the ratio of applicants to open positions actually has declined.
  • One possible explanation is declining U.S. productivity. Companies may be less willing to offer compensation increases if productivity gains do not justify higher wages.
  • Demographic factors also could play a part, as retiring older workers are replaced by younger workers at lower wages.
  • The key takeaway:  The persistent weakness in U.S. wage growth could make it difficult for the Fed to follow through on its planned rate hikes in 2017 and 2018. 


Future rate hikes from the U.S. Federal Reserve (Fed) are closely tied to policymakers’ outlook for inflation, with wage growth a key factor in those expectations. With the U.S. economy at or close to full employment (the jobless rate has been holding around 4.3–4.4% in recent months), the Federal Open Market Committee (the Fed’s policy-setting arm) needs only the conviction that inflation will reach its target of 2% “over the medium term” for it to tighten policy further. 

Unfortunately for the Fed’s rate-hike plans, the evidence on broad price measures has moved in the opposite direction over the past several months. Headline and core (that is, excluding food and energy prices) measures of inflation have declined. Fed chairwoman Janet Yellen and other Fed members have tried to characterize these declines as “transitory” and a result of idiosyncratic factors such as price wars among wireless service providers. 

Whether recent declines are transitory as such or persistent is open to debate, but the Fed, under the direction of Yellen, a labor economist before she joined the central bank, could still find justification for a rate hike if wage growth were to accelerate over the next several months. Sizable increases in average hourly earnings (as compiled by the U.S. Bureau of Labor Statistics [BLS]) may finally reinforce the confidence some Fed members have in the Phillips curve, which posits an inverse relationship between wage growth and unemployment. Analysis of historical wage growth relative to unemployment and to the availability of jobs suggests that although higher wages may be overdue, their rise, and, therefore, Fed justification for a December rate hike, may not be imminent.  

Curve Trouble
So far in the current economic cycle, growth in wages and salaries has failed to follow the previous pattern of rising notably when unemployment drops. Chart 1 reveals that the rise in wages when unemployment dropped below 4.5% in 1999, and again in 2007, is clearly missing today. 


Chart 1. Unemployment Has Fallen—Where’s the Wage Growth?
U.S. wage growth (average hourly earnings, in percent; left axis) and unemployment rate (in percent; right axis), March 1998–June 2017

Source: U.S. Bureau of Labor Statistics. The data reflect wage and salary growth for all civilian workers, both government and private, based on the Employment Cost Index.  


For whatever reason, the Phillips curve is not working the way it’s supposed to in this cycle. According to the BLS, growth in wages and salaries exceeded 3.5% in late 1999 and 2007, when unemployment fell to the levels we see today. In the current recovery, even though unemployment has declined, from 10% in 2009 to 4.4% today, year-over-year growth in wages and salaries was only 2.5% as of August 2017, according to BLS data. 

One interpretation of the slow growth in wages and salaries could be that the current sluggishness represents “the calm before the storm,” with larger increases yet to come as labor cost pressures mount.  However, the fact that since March 2017 unemployment has been at 4.5% and below without appreciable wage and salary growth suggests little build-up of wage pressures.

Record Openings
Could the failure of the Phillips curve, when low unemployment is not producing higher wages and salaries, be explained by a relative lack of available jobs? No. In fact, we have anything but an absence of jobs. The Job Opportunities and Labor Turnover Survey, one of Yellen’s preferred indicators of labor activity, most recently revealed a record 6.2 million U.S. job openings in June 2017. 

Comparing the number of applicants to the number of job openings, this ratio, at 1.1:1.0, matched the lowest reading in history, again indicating tightness in the labor market. In the past, once the applicants to available jobs declined below 2.0:1.0, wages began to rise noticeably within six months. In this cycle, the rise in wages is barely noticeable. The applicants-to-jobs ratio first declined below 2.0 to 1.0 in December 2014. Two and a half years later, wages are growing at a pace of only 2.5%. 

Perhaps, at some point, employers will need to offer increased compensation to attract qualified candidates to fill a growing number of jobs. But even as the number of job openings increases, we do not seem to be on track for compensation to quickly spiral higher. 

Other Explanations
If a tight labor market, according to traditional measures of unemployment and the applicants-to-jobs ratio, has failed to produce rising wages and salaries, perhaps there is another factor that has affected compensation. Low U.S. productivity relative to earlier periods might be an explanation. Companies may be less willing to offer compensation increases if productivity gains do not justify higher wages. The decline in productivity has been difficult to explain, and there seem no obvious measures to solve the problem. 

To be sure, low productivity may be related to weak business investment. But if business spending is dependent on expectations for stronger growth, persistent U.S. gross domestic product growth, at around 2% since the end of the recession of 2008­–09, suggests little incentive for businesses to radically change their investment behavior. Meaningful U.S. fiscal stimulus could change business investment, and, eventually, wages and salaries, but legislative efforts along those lines have so far been unsuccessful. 

As far as productivity, business investment, and fiscal stimulus, there seems little that is likely to soon influence the trajectory of wages and salaries, or broader measures of inflation, and, thus, the Fed’s comfort level with pursuing higher interest rates.

“Silver Tsunami”
In the Fed’s search for an explanation for slower than expected growth in wages and salaries, it may be looking beyond traditional causes. A study by the San Francisco Federal Reserve bank, for example, suggests that demographics may be the culprit behind the slow-wage phenomenon. The study (released on August 14) concludes that as higher-paid baby boomers exit the U.S. workforce, they are being replaced with younger workers at a lower pay rate. This, according to the San Francisco Fed, has pulled down average wages and slowed the pace of wage growth. 

While this may be an effective explanation, the study also reports that this “’Silver Tsunami’ will "continue to be a drag on aggregate wage growth for some time.” Thus, even if we have found a valid explanation for the perplexing persistence of slow wage growth, the trend likely will remain in place, as will its impact on broad measures of inflation.

Fed Impact
The Fed may have a difficult time gaining comfort that wages and salaries are on track to grow rapidly enough to pull broader measures of inflation higher. Those measures may be affected by some transitory factors, such as the drop in oil prices and reduced wireless phone bills. But the disruptive effects of price-reducing innovators, such as Amazon, Airbnb, Uber, and technological developments, such as drones and robotics, could be more persistent in holding down inflation. 

The stubbornness of inflation-containing developments—barring meaningful fiscal policy stimulus in the months to come—combined with demographic effects on wage and salary growth, could make it difficult for the Fed to follow through on its planned rate hikes in 2017 and 2018. Perhaps these factors explain why, according to Bloomberg, investors are discounting only one rate hike between now and the end of 2018.


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