Back in mid-2013 David Rosenberg infamously flip-flopped from deflationary bear to inflationary bull. That's ok - everyone has a right to change their mind (for whatever reason, even if said reason involves a direct interest in selling more newsletter subscriptions).
However, the catalyst that Rosenberg saw as the progenitor to a broad inflationary wave in the US economy was a surprisingly weak one: wage inflation and rising labor costs.
"Weak" because as can be seen quite clearly in the labor market one year later, there has been virtually no wage inflation and as we showed last month in "No Raise For You: Earnings Growth Drops To New Post-Lehman Lows", if anything the fear among the bulk of the population is that wages will remain at best flat if not continue to stagnate in both nominal and certainly real terms. This month's below expectation print in average hourly wages, which was unchanged from March, merely confirmed this.
But while we have explained time and again why the possibility (and probability) for rising wages in the US (and certainly in poor Japan which despite massive QE just reported 22 consecutive months of declining base wages) is slim to none, others - certainly those who also have a vested monetary interest in pitching the bullish, inflationary case - were largely on the sidelines of this argument, if not also notable bulls that a pick up in wages is just around the corner.
However, one Wall Street strategist who appears to have thrown in the towel on the entire rising wages debate is none other than BofA's chief economist, Ethan Harris, who in a note released on Friday fires the proverbial shot across the David Rosenberg bow regarding rising wage pressures: "Don't hold your breath."
From Bank of America:
Inflation: sour cherry
By some accounts inflation is always just around the corner. Rising gold prices, surging bank reserves and a weak dollar have each taken their turn “predicting” imminent inflation. The latest concern is that tight labor markets will trigger a surge in wages. Indeed, the hottest inflation chart these days shows average hourly earnings for production and non-supervisory workers, troughing at 1.3% in October 2012 and accelerating to 2.3% for the latest reading. As one of our competitors argues: “it should be obvious to everyone by now that there is wage inflation in the pipeline.”
How worried are we? In our view, the wage measure that Inflationistas like to point to is the least reliable of four major measures of compensation growth. Plotting this series alone is a blatant example of “cherry picking” to tell a story. A number of years ago the Labor Department replaced the old average hourly earnings series with a better, broader measure. The older series only exists because it has a long history. The three most important measures of labor compensation—including the new and improved average hourly earnings series—remain glued to 2% (Chart 1).
So far, so good, but doesn’t the drop in the unemployment rate signal rising wages? In particular, since the long-term unemployed have a very hard time finding a job, shouldn’t we focus on the short-term unemployment rate, which at 4.1% is already 0.6pp below its historic average (Chart 2)?
Don’t hold your breath: serious wage pressure is a long way off for four reasons.
- First, it is not at all clear that we should ignore the long-term unemployed. As Fed economist Michael Kiley points out, short-term and long term unemployment are normally highly correlated, so studies that try to distinguish their impact on inflation must rely on just a few years of data. Small sample and “multicollinearity” problems make these estimates very unreliable. Kiley gets around these problems by using regional data. Using data for 20 metro areas over a 20-year period, he finds that both short- and long-term unemployment matter, with similar coefficients. We prefer to split the difference between Kiley’s results and others that focus only on the short-term rate: while more weight should be given to the short-term unemployed, the weight on the long-term jobless for wage determination should not be zero.
- Second, if we are going to throw out the long-term unemployed in our measure of slack, surely we should also take into account hidden unemployed such as discouraged workers, those opting for additional schooling, and involuntary part-timers. We could easily boost the unemployment rate by a percentage point if we try to capture hidden unemployment.
- Third, even if we are at full employment, it does not mean surging wages. Most of the recent research on wage and price inflation finds a very slow, lagged response to labor market tightness. The Phillips Curve appears very flat. For example, in Kiley’s estimates, a one percentage point drop in the unemployment rate adds 0.1 to 0.2pp to inflation in the first year and 0.2 to 0.3pp in the second year. Most of the discussion of inflation risks ignores this important empirical result and makes it sound like inflation is an explosive process. Both history and models show that it takes a long time to get going (but can also be hard to reverse if it gets too high).
- This brings us to our final point: rising wages are a good sign for the economy, not something the Fed would want to prevent. As Fed Chair Janet Yellen has suggested, in a normal labor market we would expect wages to grow at about a 3.5% rate: 2% to cover the rising cost of living and 1.5% to cover productivity gains. Currently, downward pressure from high unemployment is holding wage growth to just 2%.
The upshot is that investors should not be on the edge of their seats waiting for the first hint of wage acceleration. As labor market slack shrinks, we would expect wage growth to slowly pick up. In our view, the Fed would probably be comfortable with wages accelerating by about 0.5% per year, bringing wage inflation back to normal by the end of 2016.
Of course, Bank of America has its own axe to grind: that the Fed will continue its easy policy indefinitely. Perhaps: if one goes by wage inflation as the driver of unconventional policy, then sure. However, as we covered earlier, the main driver behind the end of QE had nothing to do with wages or hedonically-adjusted inflation (or deflation), and everything to do with bond market technicals, namely the soaking up of bond market duration by the Fed. Quite clearly, the Fed's primary (and only) directive - to push stock prices higher - has found its offset in the bond market offset, where liquidity is so low everyone is now complaining.
However, once QE ends, the question of just how reliable good, old-fashioned ZIRP will be to keep stocks at record high manipulated levels remains as unanswered as every other time when the Fed moved out from direct flow manipulation (see end of QE1 and QE2). It is here that the Fed's forward guidance, the "dots", and so on, comes into play - Yellen is now desperate to show that there is no need to sell risk assets as long as the front-end doesn't increase, even as she hopes that the primary driver of price action was not ZIRP by QE.
So as for what happens if and when the Fed is fully out of the "flow" business by the end of 2014, the jury is still out. What is clear, however, is that anyone who has been calling for standalone rising wages as a function of either monetary and/or fiscal policy and the "improving" economy has so far been dead wrong. What happens to wages if the stock market begins to sell off in earnest hardly needs an explanation.
But for now watch this space closely: with all other labor market "forward guidance" indicators dead and buried (remember, in December 2012 the Fed promised it would hike rates once the unemployment rate hit 6.5%, a statement we mocked at the time for precisely the same reason why everyone else is mocking it now - namely the ongoing collapse in the labor force), wage growth (or lack thereof) remains the key variable watched by Yellen, and by others who swear up and down rising wages as a progenitor to that long-await economic recovery.
So far, the economic recovery has yet to appear. What we do have, however, are endless reasons and justifications why not: such as "harsh weather", which somehow managed to chop off hundreds of billions in US GDP in the first quarter. Or China. Or Europe. Or Ukraine. Or younameit: after all the world is priced to such perfection anything else happening needs an immediate excuse.
Perhaps a far more important question than whether wages will finally rise is how many more years after the NBER-defined end of the recession in 2009, will the US economy need before its performance is finally taken at face value, and the apologists are forced to, once and for all, shut up?