Who’s Afraid of Higher Wages Driving Inflation?

 

March 5, 2018 [Fixed Income, market volatility, U.S. stocks, market correction, sell-off]
Danan Kirby, CFA


Not necessarily the Fed, whose own research suggests wage growth is not a reliable indicator of future inflation. But markets, it appears, aren’t sure what to think.

♩ Hey Mr. President - All your congressmen, too - You got me frustrated - And I don't know what to do - I'm trying to make a living - I can't save a cent - It takes all of my money - Just to eat and pay my rent - I got the blues - Got those inflation blues ♬♫ - Inflation Blues – B.B. King (1983)


 

U.S. jobs and particularly wage data in February sparked a global selloff in equities, although stocks have since clawed back a little ground in volatile trading. Fears about the pace and extent of benchmark interest rate tightening ahead have continued to whipsaw markets, and not just in equities, but bonds and foreign exchange as well.

Market swings, of course, are nothing new, but the standard assumption that wage growth drives inflation shouldn’t be taken at face value. At least a handful of U.S. Federal Reserve bank presidents and the economists they task with economic research certainly don’t.

Inflation, it turns out, may help predict wage growth, which on a seasonally adjusted annual basis hit 2.9% in January 2018. U.S. headline inflation last month hit 2.1%. If inflation does drive wages higher, it will no doubt be a welcome development for lower- and middle-income workers, who have seen years of tepid wage growth. It’s too early to say that wages will grow sustainably from here. But, the December tax reform means businesses will have more money to spend on workers, who with a 4.1% unemployment are likely getting harder to find.

Lower income tax withholding also means workers will have more to spend. And with consumer confidence, as measured by the Conference Board, running at an 18-year high, less tax withholding coupled with any continued wage growth should prove a tailwind for inflation, if consumer demand for more goods and services does rise. Time will tell if a cyclical feedback loop supporting the “wage-price spiral” you may have read about materializes.

Several Fed policymakers have recently downplayed the notion of higher wages translating into higher prices:

  • San Francisco Fed President John Williams in Honolulu on the wage growth figure: “I do not see this as a sign inflation is moving faster than I expected.”
  • St. Louis Fed President James Bullard at a conference: "I caution against interpreting good news from labor markets as translating directly into higher inflation. The empirical relationship between these variables has broken down in recent years and may be close to zero."
  • Dallas Fed President Robert Kaplan in Frankfort: “We’re facing wage pressures right now in the United States because of a tight labor market. I am less convinced that this will necessarily translate into higher prices because businesses have much less pricing power.”

The Federal Reserve’s own research provides insight to why some regional Fed presidents don’t align with the “wage increases boost inflation” scenario. DataTrek Research compiled the following examples:

  1. Wage growth could help predict future inflation when looking at their relationship from 1952 to 1999. With that said, it was colored by the large timeframe between 1966 and 1983 when inflation “steadily accelerated.” But when inflation “remained low to moderate” from 1953 to 1965 and 1984 to 1999, wage growth did not help predict inflation. Rather, “inflation always helps predict wage growth, a finding that is both quantitatively significant and stable across subperiods.” —Richmond Fed
  2. Likewise, researchers at the Dallas Fed found that when looking at productivity-adjusted wages and inflation from 1960 to 2009, “wage growth does not cause price inflation,” which is “particularly true for the period from 1984 and onward.” They also concluded that “price inflation does cause wage growth” and that their findings “do not support the claim that slow wage growth is a harbinger of low inflation.” —Chicago Fed
  3. For what it’s worth, the Dallas Fed published similar findings and concluded that when “assessing future inflation,” their results “suggest that policymakers and analysts should put little weight on recent wage trends.”
  4. Recent research from the San Francisco Fed also found that “fundamentally, the weak forecasting power of wages for prices suggests that unexpectedly high or low inflation could occur regardless of the recent behavior of wages.” Moreover, “the overall conclusion of the literature is that wages generally provide less valuable insight into future prices than some other indicators. In fact, models that do not incorporate wages often result in superior inflation forecasts.”

Inflation is full of mysteries, but this shouldn’t be a surprise. Economies are complex systems, and the interaction of multiple variables can lead to less-than-intuitive results. In today's markets, which appear to be more driven by narrative than data, it's important to build robust portfolios that are sufficiently diversified and don’t depend on singular macro bets based on forecasts for growth, inflation, deficits, etc. Over the long-term, all-weather portfolios built with carefully selected individual securities offering attractive risk-reward propositions and differentiated exposures should deliver better results.

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