posted on 27 October 2015
by Gene D. Balas
Recent trends suggest that the traditional relationship between employment and inflation could be turned on its head. Economic theory has long held that, when the unemployment rate falls, tighter labor markets would force wages - and thus inflation - higher. This forms the basis of the Phillips Curve, which formalizes this relationship.
However, that hasn't seemed to hold true in the current environment, where unemployment has now fallen to 5.1%, according to data from the Bureau of Labor Statistics, almost to levels believed to be "full employment," and where inflation would normally begin to reassert itself. Wage gains, however, have not accelerated. Recently, several notable Fed policymakers, including Fed Governors Lael Brainard and Daniel Tarullo, have observed that the Phillips Curve might not be instrumental as a foundation of monetary policy in the current environment and that traditional relationships may not now hold true.
Indeed, observe on the graph above the inverse relationship between the unemployment rate (red line) and hourly earnings (blue line), in data from the Bureau of Labor Statistics. This typical relationship - wages tend to rise when unemployment falls and vice-versa - can be observed up until the past few years, when hourly earnings have trended lower, even while the unemployment rate continued to fall by a remarkable amount.
Here's another wrinkle: job openings, reported by the Bureau of Labor Statistics in the Job Openings and Labor Turnover Survey (or JOLTS report), surged to nearly a record high (green line on the graph below) since the recession-era nadir, yet hiring (blue line) has failed to keep pace at the same rate. Indeed, the past two jobs reports from the Bureau of Labor Statistics have disappointed, with fewer new jobs created than investors expected and with muted wage gains. Meanwhile, the number of employees who quit their jobs (red line) - presumably to take a better-paying job - has failed to rebound to its prerecession peak. There are a number of theories on why companies are slow to fill those open positions - and why workers are not leaving their current jobs to take new ones - and these have centered on a few different theses.
One factor might be that companies aren't finding qualified workers. Bill Dunkelberg, the Chief Economist of the National Federation of Independent Businesses (NFIB), noted,
In fact, 53% of small businesses reported job openings, and 45% of them reported having few or no qualified applicants, according to the most recent NFIB monthly Small Business Trends report.
So, thus far, that thesis observed by the NFIB that wage gains may become evident dovetails nicely with the economic theories of inflation and labor market tightness. However, the question is will employers offer those higher wages, or will companies simply allow job openings to go unfilled?
When businesses make a decision to hire someone, they must also consider whether that hire would be profitable. In other words, paying higher wages would make sense - if companies could raise their prices or increase their sales in tandem. But if a company might doubt whether the added wage expenses could be offset through higher prices, they may hold off on increasing starting pay or giving their existing workers pay raises.
Thus, rather than higher wages pushing inflation higher, persistently low inflation - and expectations that inflation would continue to be low - may restrain hiring, to the extent that a new hire would require higher pay. Continuing with data from the NFIB survey, we see that only a net one percent reported raising their selling prices in September, and a net 13% plan to hike prices in the coming six months. Meanwhile, a net 16% planned to raise compensation in coming months. The report noted, "There are no signs of inflation bubbling up on Main Street."
Certainly, should employers expect higher prices in months ahead, they might likely consider raising compensation levels in tandem. Herein lies the Fed's dilemma: it wants higher inflation, but in order to do so, it needs to inspire businesses to expect the Fed to be successful in that regard. And so far, the Fed has failed in its mission to achieve its 2% inflation target. In the Fed's preferred inflation gauge, the one tied to personal consumption expenditures published by the Bureau of Economic Analysis, we see that inflation increased by just 0.3% from a year ago and by 1.3% excluding food and fuel.
So, until and unless business owners can be convinced that they can raise their selling prices by more than this amount, or if they can achieve production increases augmented through productivity gains, employers may simply allow job openings to go unfilled. That can restrain hiring, and economic growth more generally. And, most importantly, it is an instructive lesson on just why it is that the Fed wants to increase inflation: higher inflation expectations can actually be good for hiring and economic growth more generally.
This was posted originally in Investment Mangement Market Reflections, United Capital Financial Life Management, 21 October 2015 and is reproduced here with permission.
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