One challenge, both for ourselves as investors and for Federal Reserve policymakers, is to understand why any pressures on US wages have been (apparently) dormant despite the sharp decline in the unemployment rate.
Other than average hourly earnings (AHE) and the employment cost index (ECI), a broad range of indicators suggest that the labour market is approaching supply constraints. Yet although the U3 unemployment and U6 under-employment rates fell to 4.1% and 8.1%, respectively in December 2017, overall AHE growth has actually retreated from 2.9% year-on-year in February 2017 to only 2.5% year-on-year in December.
One answer to this puzzle is that AHE is actually a poor measure of overall compensation trends since it is distorted by compositional considerations (older, better-paid workers leave the labour force and are replaced by younger, cheaper workers). And there are a lot of baby-boomer’ retiring, increasing the distortion.
The Atlanta Fed Wage Tracker adjusts for this bias by looking at cohorts of employees who have been in the same job for 12 months, from the Current Population Survey. This methodology convincingly demonstrates that US wages have actually been growing at a rate of between 3% and 4%, depending on age group, education and skill level.
Job switchers are doing better still. In our view, it is just a matter of time before we see confirmation of this trend in the Fed’s favourite measure of compensation rates, the ECI. Nevertheless, we caution that rising wages do not automatically mean consumer prices will also accelerate.
Atlanta Fed Wage Tracker: year-on-year gains in US wages by occupation (12-month average)
Source: Atlanta Fed, as of 11/01/2018
Inflation developments in fourth quarter 2017
The core consumer price index (CPI) and personal consumption expenditures (PCE) failed to accelerate in the fourth quarter, prompting more hand-wringing from a number of FOMC policymakers. The weakness was concentrated in volatile components such as apparel and airfares, but also seen in the cost of medical care and shelter. The table below provides a heatmap of monthly changes in major CPI categories.
Monthly CPI changes (month-on-month)
Source: St. Louis Fed, as of November 2017
Yet the 2017 hurricanes are expected to impact CPI in two ways over the coming months.
- First, the damage to the housing stock from hurricanes Harvey and Irma is likely to put upward pressure on rents and owners’ equivalent rent (OER), especially in Houston, Texas and Florida. This would be a temporary reversal in the softening of recent months which has occurred amid a modest increase in rental inventories.
- Second, the flood and wind damage to vehicles has triggered a replacement cycle that has already pushed up used vehicle prices in November and December.
Considering the 2018 inflation outlook, our view is that transitory factors such as the collapse in cell phone plan prices in March 2017 can explain a large portion of the 2017 decline in YoY inflation growth and that base effects will allow a recovery in CPI in the first half of 2018, assisted by hurricane effects on rents and vehicle prices. However, structural weakness in sectors such as medical care and education (which are largely non-cyclical) will remain a headwind to core inflation.
Furthermore, we are concerned that the tightening labour market has not generated faster real growth in US wages to date, which may also indicate that the Phillips curve (the relationship between output slack and wage gains) has flattened in this cycle.
As mentioned earlier, even if one takes the Atlanta Fed Wage Tracker indices as the correct measure of compensation trends, unit labour costs are still not rising. We also worry that the persistent undershoot of inflation in recent years has undermined inflation expectations which may be becoming unmoored. The gradual declines in various inflation surveys are certainly consistent with that possibility.
Putting it all together, we expect headline inflation to recover due to base effects in 2018, but a combination of structural drags and a flat Phillips curve means that core inflation will likely return to target only very gradually.
One source of upside risk to our benign inflation outlook comes from the remerging risk of protectionism. With the Trump administration under considerable scrutiny on a number of fronts, and with tax reform completed, it is entirely possible that the next area of focus will be to seek renegotiation of current trade arrangements – particularly with North American Free Trade Agreement (NAFTA) partners and China. Should trade discussions trigger the imposition of tariffs, we could again be looking at the prospect of higher import prices, and possible retaliation.