by Lakshman Achuthan, Co-Founder and Chief Operations Officer of ECRI
A keystone of current market complacency is the growing conviction that, with wage growth flagging, the Fed will not hike rates sooner or faster than expected. Yet, so much depends on just how far behind the inflation curve the Fed will find itself.
In this regard, ECRI has a fundamentally divergent view, with very different implications for the management of cyclical risk. Our perspective is based on our cyclical analysis, including the U.S. Future Inflation Gauge (USFIG), which has climbed to a six-year high as underlying inflation pressures have mounted.
Certainly, Fed Chairman Janet Yellen has tried to allay rate hike concerns, noting that real wage gains “have been nonexistent.” But the critical issue is Ms. Yellen’s contention that, as a result, “there is some room … for real wage gains before we need to worry that that’s creating an overall inflationary pressure for the economy.” Her observation is in lockstep with the received wisdom among economists that changes in wage inflation precede those in consumer price inflation.
As we demonstrated over a decade ago, inflation downturns often follow nominal earnings growth downturns, but inflation upturns “do not wait for wage growth upturns” (USCO, June 2004). However, it seems quite difficult for econometric models to capture this cyclical asymmetry and the variability of leads that characterizes this relationship. The resultant modeling errors may underlie the erroneous belief that inflation upturns follow wage growth upturns, likely feeding the ever-popular story of “a virtuous wage-price spiral” that we debunked earlier this year.
Ms. Yellen’s current complacency about inflation is somewhat different, being rooted in the absence of real wage growth. In effect, she suggests that stronger real wage growth is a prerequisite for higher inflation. Does the evidence support this view?
The chart (lower panel) shows not only that year-over-year (yoy) real Average Hourly Earnings (AHE) growth for all employees is now at zero, but also that real AHE growth for production and nonsupervisory workers (light blue line) is near zero. Indeed, the cyclical movements in these two measures are very similar.
The upper panel of the chart shows yoy CPI growth inverted (black line), with red shaded areas depicting cyclical upturns in CPI growth. Thus displayed, it is evident that both blue lines in the lower panel closely follow the movements of the black line in the upper panel.
This is essentially a matter of arithmetic. Because the blue lines show real AHE growth, i.e., deflated by the CPI, periods of rising CPI inflation (red shaded areas) are generally coterminous with declines in those blue lines. In other words, higher inflation eats away at real earnings growth. So, when nominal AHE growth is at only around 2%, and CPI inflation also around 2%, real AHE growth is effectively “nonexistent.”
As the chart shows, it is mostly during periods of substantial declines in inflation (shown by a rising black line) that the measures of real earnings growth (blue lines) surge well above zero. Historically, going back at least to the Volcker era, these have hardly ever been the periods when the Fed has begun rate hike cycles. Indeed, Mr. Volcker started rate hike cycles only when inflation was high and real AHE growth was negative – sometimes strongly negative (not shown).
Likewise, his successor, Alan Greenspan, raised rates in 1987 and later in 1988-89 only when real AHE growth was negative (not shown). Mr. Greenspan’s next series of rate hikes, in 1994-95, arrived when real AHE growth was around zero, just before CPI inflation started creeping up (see chart). The rate hike cycle that followed, in 1999-2000, was the only one to begin when real AHE growth was well above zero, though already falling as inflation rose. Mr. Greenspan’s final rate hike cycle, in 2004-06, began when inflation was rising and real AHE growth was clearly negative and falling.
So the modern Fed, going back at least to the late 1970s, has scarcely ever raised rates with real AHE growth well above zero – which is when Ms. Yellen now says she would “need to worry” about inflation pressures. The solitary exception was near the end of the late 1990s boom, when the Fed started raising rates less than a year after the USFIG began a cyclical upswing, following an unusual period of robust non-inflationary growth enabled in part by healthy productivity growth.
The current cyclical period is different. Most importantly, productivity growth has been quite weak in recent years. Moreover, as Ms. Yellen put it, “real wages have been rising less rapidly than productivity growth; and what we’ve seen is a shift in the distribution of national income away from labor and toward capital.”
In the late 1990s, the opposite was true, and productivity growth had stayed strong for years. Such were the unusual circumstances on the sole occasion when the modern Fed began a rate hike cycle with real AHE growth well above zero. To enable a repeat performance, we would need to see a reversal of the current patterns of falling labor share of income and low productivity growth. Yet it is not clear why the labor share will rebound anytime soon, or why productivity growth will ramp up, especially in light of the prolonged weakness in business investment.
The U.S. economy’s “potential GDP growth” is officially estimated to have been over 3% in the late 1990s. As we noted recently, the official estimates for the coming years have dropped to around 2%, while private estimates are lower. Under such circumstances, even relatively weak economic growth can be inflationary, and the Fed would not have the luxury of waiting to hike rates until real AHE growth rose well above zero. Indeed, this is consistent with the current upturn in the USFIG.
Yet, if inflation remains in a cyclical upswing, as we predict, it would eviscerate real earnings growth, presumably pushing off the day when Ms. Yellen starts worrying about inflation pressures. If so, armed with monetary tools known to act on the economy with long and variable lags, the Fed would find itself far behind the inflation curve. In such a scenario, the Fed could certainly act to bring inflation back under control, as Mr. Volcker did in the context of double digit inflation. The question is how the economy and the markets would react.