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This is an excerpt from our most recent Economic Outlook report. To access the full PDF, please click here

With unemployment being close to, or even below, what’s termed the natural level of unemployment (NAIRU), i.e. the level of unemployment that Economists consider to be the lower limit below which inflationary pressures emerge -- it remains challenging to explain Why we are not observing stronger increases in consumer price levels? By the way, the U.S. Congressional Budget Office estimates the natural rate of unemployment for the 2nd quarter in 2017 to be 4.74%.

This unusual behavior displayed by consumer inflation, measured by either core CPI or PCE (the FED’s preferred measure) is sending a thumb’s down to the FOMC on its plans for a gradual rate hike path. In recent statements, Fed officials have attributed the unwelcome consumer inflation developments to secondary sources, such as cellphone-service plans and prescription drugs coming off patent. Nonetheless, the most powerful driver remains the subdued wage growth, when compared to pre-2008 recession times.
 
The labor market is strengthening. It is allowing discouraged individuals to re-enter the market. Employers are finding it increasingly difficult to fill their openings. Yet, none of these developments manifests itself in ample wage growth. Despite 2 million new U.S. jobs added over the last year, and unemployment below 4.5%, wage growth remains at levels below +2.0%. This is far below levels observed prior to the financial crisis in 2007. Then, consumer inflation held above +2.5% when unemployment rates where at a similar level (see below).

There are a number of possible explanatory factors. These include competitive forces, as production is being moved to emerging economies; and increases in the labor force participation rate. These underling factors are not unique to the current period however.

Researchers at the Federal Reserve Bank of San Francisco have suggested an alternative explanation. Theirs offer an intuitive appeal. Following their argument, the sluggish wage growth is not a sign of weak labor market but rather an indication of “cyclical and secular shifts in the composition” of the labor market.

That’s a mouthful. What that means is the U.S. labor market is coping, as increasing numbers of aging “baby boomers” retire. We are living in a period of time where a particularly large share of individuals -- with high skills, high seniority, and hence high salaries-- exit the labor market. Meanwhile, many individuals (think about young women who stayed home to rear children) were sidelined during the financial crisis 2008. They are now re-entering the labor market --at lower salaries-- creating further downward overall wage measurement pressure. Combine both effects. These can then create the type of low growth rates we observe on wages.

Another large driver of the wage growth, or the lack thereof, remains low productivity growth. Real wage growth has not followed productivity growth in tandem over the last decades. But a close relationship remains. We should expect wages to move along productivity. With current productivity growth levels around +0.2% for Non-Farm Business Labor Productivity, the lack of wage increases should not come as a surprise. In fact, in her recent testimony to the House Financial Services Committee, Federal Reserve Chair Janet Yellen attributed low wage growth to low productivity. She stated this as the major driver of long run limits on wage growth.

With all of the aforementioned factors co-mingling to affect wage growth in upcoming months, it will remain difficult to project an exact growth path. But we remain tepidly optimistic. With diminishing slack in the labor force, the labor force participate rate will meander towards pre-crisis levels. Employers will be forced to increase wages, in order to fill positions. We should see higher wages return.

This is an excerpt from our most recent Economic Outlook report. To access the full PDF, please click here




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