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Have Reports on the Death of Low Inflation Been Greatly Exaggerated?

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

Stock markets were shaken by the U.S. Labor Department’s report of rising wages at the beginning of February. Market participants seemed to view this as a clear sign of inflationary pressures.

(See the yellow area in the above graph? It highlights the current 10-Year Breakeven Inflation Rate)

Bond traders (aka the “smart money”) thought this. Anticipated higher inflation was expected to subsequently lead to higher interest rates, through a more aggressive Fed in 2018, and higher long-term yields from greater U.S. fiscal finance needs. A self-fulfilling prophecy was set in motion.

This led to an increase in perceived risk and volatility across other financial markets. It pushed down nearly all major U.S. and global stock indexes swiftly. The swoon lasted throughout February.

Most -10% stock market corrections like this last 2 months. So buckle your seatbelt until April.

However, was all the commotion justified?

The change in average hourly earnings of +2.9% did indeed represent a new high, the likes of which we have not seen since June 2008.

As can be seen – in the graph below – this most recent reading is part of a gradual average hourly earnings growth upward trend. This can be seen over the last 5 years. An earlier U.S. wage rate collapse appeared to have bottomed out, about three years after the 2008-09 financial crisis.


A look under the hood of the latest numbers reveals some important details:

1)    The wage increase did not occur across the board for all workers. It focused on a subset of supervisors and non-production workers who make up less than 20% of that measure. In July 2016 we saw a similar peak in the earnings growth of 2.8%, which was driven by this small subset and did not lead to a break out in wage growth. Meanwhile, wages for nonsupervisory workers, which make up the remaining 80%, saw only an increase of 2.4%, which is much more in line with the previous months. Therefore, we see no reason for a premature declaration of wage inflation.

2)    Investors appeared to interpret signs of wage growth unanimously as an indication of increasing consumer inflation. Most Fed officials remain confident in this transmission mechanism. That is, tighter labor markets and higher wages ultimately leading to inflationary pressures (a transmission mechanism typically referred to as the Phillips Curve). However, the most recent years provide ample evidence. The relationship might not hold in that manner, or might at least reveal longer delays in the transmission process.

3)    In fact, note in the two graphs below. The annual CPI and PCE changes indicate relatively low and stable rates since the 2008-09 financial crisis. They do not reflect the subtle upward trend seen in the average hourly wage growth chart.

Notice too: for both measures of consumer inflation, the majority of the volatility is accounted for by food and energy components (the red line). Once both measures accounted for this standard source of noise (the blue line), neither inflation measure seems very impressed by wage growth.

Based on these observations, we stay sanguine about the ultimate effects of wage pressures. But we remain cautious about their immediate ability to transfer into higher inflation. We expect that, in order for wage growth to cause major inflationary pressure, we need to see an uptick in the group of non-supervisory workers that make up 80% of the statistic.

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