The “Real” Wages Story – Pun Intended

What’s going on with Wages, “Really”??

The Fed meeting starts today – 31st January. And it is almost certain to raise interest rates by 25 basis points. The real event though is tomorrow – What would be Chair Powell’s message to the markets at the conference later?

The Fed’s narrative has changed over the last 12 months – and understandably so. In late 2021 and early 2022, the Fed was concerned about high headline inflation and high goods inflation. One of the key concerns was high current inflation can cause medium term inflation expectations to get unanchored. Given that inflation has come down substantially in the 2nd half of 2022, the Fed’s focus now is wages – spotting and preventing any signs of a wage price spiral.

What is a wage price spiral?

The wage price spiral is a phenomenon which suggests that rising wages leads to more disposable income which raises the demand for goods and services causing prices to rise. Rising prices of goods and services leads to workers demanding even higher wage increases which leads to a higher production cost and puts further upward pressure on prices – creating a self-sustaining spiral!

For the more economically inclined – compensation growth equals inflation plus productivity growth. If compensation increases and productivity falls or remains the same, inflation increases. Wages are a large share of firms’ costs (especially in the Services sector), If wage growth exceeds productivity growth, firms are inclined to raise prices to protect profit margins – which can lead to higher inflation.

What is consensus view / mainstream media telling you?

Consensus view is telling you that real wages are falling. And that has been true for much of last year. Here are some examples

Source: ILO

ILO Quote “ In Northern America (Canada and the United States), average real wage growth slid to zero in 2021 and dropped to minus 3.2 per cent in the first half of 2022.” Unquote

Source: Bloomberg

Bloomberg Quote” The pivotal question for Fed officials is whether the climb in US pay over the past 18 months or so is a one-time bump — as companies adjust to scarce labour supply, and a realization that their workforce was under-compensated — or a pernicious feedback loop in which prices and wages drive each other up.” Unquote

The red line in the graph above (Wages) has been below the blue bars (Inflation) for most of 2021 and 2022 – when wages have not kept pace with inflation and this has eaten into purchasing power of most consumers.

While this is undoubtedly tough especially on the lower income segment of the population, this is good news from the perspective of slowing down demand, reigning in inflation and slowing down further monetary policy tightening.

What else do I need to know?

The below chart below shows the month-on-month growth of Real average hourly earnings. The Fed is likely to pay special attention to those last two bars on the right (marked in orange).

Source: BLS; The Credit Balance

Indeed, 2 months don’t make a trend. So we chose to look at a 3-month moving average. This is how it looks.

Source: BLS; The Credit Balance

For those who love a visual representation, below is a chart that maps month-on-month changes in inflation against nominal wages.

Source: FRED

The clear blue portions are points where nominal wages increased more than month on month inflation. Lets walk back down memory lane to mid 2022 (when similarly real wage growth was in positive territory). Powell’s message in the July FOMC was (mistakenly) perceived by market participants as bearish. We then saw a “Volckerized” Powell come out in full force at Jackson Hole to reiterate his hawkish message to the markets.

What does economic history tell us?

Just to clarify. I am, by no means, predicting that Powell is likely to do that tomorrow. But given how center-stage wage price spiral concerns are at the moment, it pays to be well informed about recent trends. In fact economic history is littered with instances of situations where ingredients were quite similar to the present ones – aka high inflation, supply side shocks and tightening monetary policy. In most of those situations a wage price spiral did NOT materialize. The IMF has highlighted this in a paper in Oct 2022. You can find the paper through this article. But the graph below adequately summarizes the findings of the paper. In summary, similar past episodes did not result in a wage price spiral.

The wonderful thing about history is that you know it happened for sure. Unfortunately, that’s not what Powell has on his hands currently. So, lets look forward to tomorrow and see if we get another “Volckerized” Powell !

Lastly, as I write this, the Employment Cost Index – considered the Gold standard for measuring wage growth – has just been released for Q4 2022. And it has surprised on the downside (1.0% growth vs 1.1% consensus). In response, the S&P Futures are up 0.3% and the 10 year UST is down 5 basis points in immediate response !

Happy Investing!

By Shashank Sawant

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