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The Waiting: Wage Growth and Inflation Finally Getting in Gear?

Key Points

  • Hurricanes impacted job growth; but not unemployment or wages, which both showed a big improvement.

  • Median wage measures tell a much brighter story than average wage measures; while the Underlying Inflation Gauge suggests more inflation than traditional measures.

  • Punchline:  Fed raises rates in December.

The waiting is the hardest part
Every day you see one more card
You take it on faith, you take it to the heart
The waiting is the hardest part

          - Tom Petty’s The Waiting

We’ve been waiting for some time for the tightness of the labor market to finally translate into higher wages; and in turn higher inflation.  Did that day come on Friday?

Friday’s jobs reported disappointed on headline payrolls—there was a net loss of 33k payroll jobs in September vs. the consensus expectation of 80k—but the weakness was largely driven by Hurricanes Harvey and Irma.  Nearly 1.5 million people were unable to work due to bad weather, the most since January 1996.  Much less affected by the hurricanes were the unemployment rate and wage growth.  According to the Labor Department, the hurricanes had a “net effect” of reducing nonfarm payrolls in September, while there was “no discernible effect” on the unemployment rate (UR).

To put the impact of the hurricanes in historical perspective, in the two months following Hurricane Katrina in 2005, payrolls averaged 76k—which was down sharply from a monthly average of 249k in the prior six months.  They ultimately rebounded to 259k per month over the subsequent six months.

Good news for unemployment and wages

In September, the UR fell to 4.2%, the lowest level since February 2001; while average hourly earnings (AHE) jumped to 0.5% month/month; which is up 2.9% year/year, up from 2.7% year/year just last month.  The UR is calculated from the Household Survey and the 0.2 percentage point drop came in spite of an uptick in the labor force participation rate.  It was boosted by the household survey employment series, which surged by 906k, which is a massive increase in a single month.

Wage growth has become a hot topic; and Friday’s release was on the hotter side.  But some enthusiasm curbing may be in order given that the hurricanes did prevent some lower-paid Americans from working, which may have biased up September’s reading.  Speaking of the vagaries of wage data, let’s dive into the numbers in a little more detail; with an update on a subject about which I’ve written quite often.

How wage math works

Although average hourly earnings are the most widely-watched measure of wage growth, it’s important to remember that it’s an “average” measure; and with that, comes some measurement problems at times.  To explain why, see the chart below which looks at a three-month smoothed average of AHE (the smoothing due to regular monthly volatility).  In particular, check out the “Great Recession” (shaded bar from late-2007 to mid-2009) and the sharp upward move in wages.  Does anyone really think that wages were surging during the worst economic downturn since the Great Depression? 

Wage growth picks up

Average Hourly Earnings

Source:  FactSet, as of September 30, 2017. Gray-shaded areas represent periods of recession.

The reality during the financial crisis and attendant recession was that a larger share of massive job losses was among folks on the lower end of the wage spectrum.  At the worst phase—late-2008 through early-2009—monthly job losses exceeded 800k per month.  What happens when you eliminate a bunch of lower numbers from an average?  The average moves up.  Fast-forward to today; we have been experiencing somewhat the opposite effect, with younger lower-wage workers moving into the workforce, in addition to the effects of flows into and out of full-time work from part-time work.

As highlighted in an August 2017 report from the Federal Reserve Bank of San Francisco titled “The Good News on Wage Growth”:

  • The drag on wage growth due to these flows into and out of full-time work reflects changes in workforce composition associated with demographics and a strong labor market.
  • Simply stated, new entrants to full-time work, whether they are entering for the first time, re-entering from periods of involuntary or voluntary non-employment, or moving from part-time to full-time work, are more likely to make below-average wages.
  • Counterintuitively, this means that strong job growth can pull average wages in the economy down and slow the pace of wage growth.
  • This is exactly what we have been seeing in recent years.  As the labor market has continued to strengthen, many workers have moved from the sidelines of the labor force or part-time positions into full-time employment.  The vast majority of these new workers earn less than the typical full-time employee, so their entry brings down the average wage.
  • This effect is even more pronounced than usual because of the large-scale exit of higher-paid baby boomers from the labor force.  With so many of this generation still approaching retirement, the so-called Silver Tsunami will continue to be a drag on aggregate wage growth for some time.

To reflect the vagaries of an average calculation, the Federal Reserve Bank of Atlanta tracks median wages.  As seen in the chart below, their Wage Growth Tracker (WGT) is a measure of the nominal wage growth of individuals and is the median percent change in the hourly wages of individuals observed 12 months apart.  In effect, by measuring only those folks in the workforce for the full measurement period, it eliminates the “mix shift” problem inherent in AHE.

Median wages hotter than average

Atlanta Fed Wage Growth Tracker

Source: Federal Reserve Bank of Atlanta calculations, as of August 31, 2017. Gray-shaded areas represent periods of recession.

As you can see when comparing the two wage measures above, the WGT shows median wage growth has been running nearly a full percentage point higher than AHE.  Perhaps AHE is beginning to catch up to WGT.  I believe it’s a distinct possibility.

Inflation conundrum

One of the conundrums facing economists—and certainly the Federal Reserve—has been the lack of both sustainable wage growth and inflation in light of a tightening labor market.  Many have questioned whether the “Phillips Curve” is dead.  As a refresher, the Phillips Curve shows—at least historically—that inflation and unemployment have a stable and inverse relationship; in other words, with economic growth comes stronger job growth and lower unemployment, which leads to inflation.

Perhaps it’s too soon to declare the Phillips Curve dead as there are indeed signs that we should put inflation back on our radar screens.  The punchline for the details I’ll share below is that we believe a rate hike by the Fed is firmly on the table by the end of this year.
Inflation has been consistently undershooting the Fed’s 2% target; yet many officials (including Fed Chair Janet Yellen) have expressed the view that some of the forces of that downward pressure are temporary—including the massive decline in wireless service costs courtesy of the “war” among providers.  We agree.  However, we concede there are also structural downward forces that are likely to remain—including globalization, digitization, automation and the “Amazon” effect on retail prices.

Will the real inflation measure please stand up?

There are many ways to measure inflation; and I always sympathize with our clients who lament that what they experience in their daily lives makes inflation “feel” like it’s higher than what’s reported in traditional measures.  Two of those traditional measures are the consumer price index (CPI) and the personal consumption expenditure (PCE) price index.  The latest (August) CPI’s year/year headline reading was 1.9%; while its core (excluding the volatile food and energy components) reading was 1.7%.  The Fed’s preferred measure is PCE, and its headline reading was only 1.4%; while its core reading was only 1.3%.

But neither CPI nor PCE tell the whole inflation story, which is why the Federal Reserve Bank of New York last month released the inaugural edition of its monthly publication of the Underlying Inflation Gauge (UIG).  The new set of measures “are constructed to provide an estimate of the trend, or persistent, component of inflation … derived using a large number of disaggregated price series in the consumer price index (CPI) …”

“An attractive feature of the UIG is that it identifies sustained movements in inflation using information from a large data set.  It has also shown more accurate forecasts of inflation compared with core inflation measures.”  So, how does the UIG compare to the CPI and the PCE?  As you can see below, its “prices only” measure has been tracking generally higher than either traditional measure for most of the time since about 2012.  As you can see, it’s also been less volatile than both CPI and PCE—likely because it incorporates a larger data set.  Notably, it’s also above the Fed’s 2% inflation target.


Underlying Inflation Gauge

Source:  FactSet, Federal Reserve Bank of New York-Underlying Inflation Gauge (, as of August 31, 2017.

Gray-shaded areas represent periods of recession.

What say you FOMC?

The most important near-term implication of what was detailed in this report is for Fed policy.  As mentioned (herein and in past commentaries), we remain firmly in the camp that the Fed has another rate hike in store for us this year—most likely at the December Federal Open Market Committee (FOMC) meeting.  In fact, in the immediate aftermath of Friday’s jobs report, the expectation for a December rate hike tracked by Bloomberg jumped to 90%.
For the first time in years, it appears the FOMC’s forecasts may have the edge in terms of accuracy relative to the market’s expectations.  As you can see in the so-called “dots plot” below—which compares the FOMC’s expected path for the fed funds rate to the market’s expected path—there remains a wide gap.

Dots plot thickens

Fed Dot Plots

Source: Bloomberg, Federal Reserve, as of October 6, 2017. Fed estimate based on median  Federal Open Market Committee (FOMC)  projections. Market estimate based on Bloomberg Euro Dollar Synthetic Rate Forecast Analysis (EDSF).

We think the market is right for 2017; but the Fed may be more right over the next year or so.  Until recently the gap had been narrowing via the FOMC lowering their expectations.  But it may now be the market’s turn to raise its expectations.


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