I need a serious break from the ugliness of DC health-care politics, so let’s talk about three interesting and related economic questions: inflation, labor demand, and consumer spending.
First, why does inflation continue to respond so weakly, if at all, to the tightening job market? The traditional response is “because the Phillips curve (the relationship between unemployment and inflation) is flat” but that’s just saying “who knows?”
There are several links in this causal chain, all of which deserve scrutiny. First, the tight labor market leads to faster wage growth. That squeezes employers profit margins and thus leads them to pass as much of those increased labor costs forward to consumers, thus lifting inflation.
Well, the figure below shows:
–Unemployment has indeed fallen to levels consistent with the Federal Reserve’s version of full employment.
–Wage growth has accelerated (“wage mashup” is a combination of five wage series). It was around 2%; it’s now about 3%.
–But inflation—I’m using the PCE core—hasn’t picked up much at all and remains below the Fed’s target rate of 2%, where it has been for years now.
You can certainly see a lot more price acceleration in the overall CPI, but that includes energy prices, which have normalized in recent months (see next figure). If you look at most inflation gauges, including the Cleveland Fed’s trimmed mean and median CPIs, you see a bit of upward drift, as you’d expect in year eight of an economic expansion wherein inflation has heretofore been uniquely low.
What I think is happening is a) inflation expectations are extremely well-anchored b) the tight labor market is delivering some wage growth but not a ton; worker bargaining power remains constrained c) though it has come down off of its recent peak, the dollar remains pretty strong, and perhaps most importantly d) wage growth isn’t bleeding into price growth.
Nevertheless, barring significant trend shifts in key variables, the Fed’s going to continue to slowly raise, for reasons that aren’t so clear to me but I think amount to: rates have been very low for very long, and as the economy gets back to normal, rates should too. I get that logic, but I think it’s at least a little hard to maintain it at the same time as claiming to be data driven.
The other thing I wanted to talk about is this measure that combines several variables to provide what I think is a useful insight into consumer demand. It’s just the aggregate, blue-collar wage bill, in real terms: hrly wg/p * avg wkly hrs * emp, all for production, non-supervisory workers (blue-collar workers in manufacturing; non-managers in services; ‘p’ stands for price level, so that’s the real hourly wage). As I note here, I find this to be a useful forecaster of real consumer spending.
The figure below plots year-over-year percent change in this aggregate variable, revealing its cyclicality. The figure below that shows a forecast of yearly changes in consumer spending based on a model using changes in aggregate wages (with some lags, an error correction term, and a lag in the dependent variable). The simple model under-predicts consumer spending in the 1990s, probably because of wealth effects spun off by the housing bubble, and over predicts in this recovery, but tracks consumer spending—70 percent of the US economy—pretty well.
Note the recent slowing of the aggregate real wage measure at the end of Figure 3, largely a function of faster inflation growth (the energy effect noted above) and some slowing of job and (blue-collar) wage growth. This slowdown corresponds to the recent slower growth of consumer spending.
Tying themes together, the labor market is tightening, helping to boost wage growth. However, core inflation has accelerated only slightly, suggesting little pass-through of wage growth to price growth. At the same time, the employment recovery has provided consumers with growing incomes, driven by more employment and higher real wages. Most recently, however, slower real wage growth among blue-collar and non-managerial workers has dinged consumer spending, and thus GDP, a bit.
This deceleration in aggregate earnings bears close watching as Figure 3 shows that such movements often, though far from always, precede recessions.