Wage Inflation: Is it Different This Time?

July 13, 2018  | by Ryan Driscoll, Kristofer Kwait

Industry Knowledge | Market Commentary

The Federal Reserve Governors have been waiting patiently for a meaningful jump in inflation to validate the removal of historically low interest rates that laid the foundation for the economic recovery since the financial crisis. And . . . while The Fed continues to wait . . . investors are wondering if this time is different?

To be fair, there has been some movement in the inflation metrics. The most commonly referred to gauge of inflation is the Consumer Price Index, which has risen from zero in 2015 to 2.8 percent most recently. However, our focus is on a more nuanced measure of inflation: average hourly earnings (i.e. wage inflation). Average hourly earnings is calculated by the Bureau of Labor Statistics and is defined as the average amount an employee in the U.S. makes per hour in a given month.

This begs the question – which part of the equation is broken?

One practical model, the Phillips Curve, contends there is an inverse relationship between the rate of unemployment and the rise in wages. Thus, it would be expected that, as unemployment in the United States hits multi-decade lows, there should be a corresponding increase in labor costs as businesses compete for skilled labor and reward employees to increase retention. However, this hasn’t been the case. In fact, over the last few years, average hourly earnings has trended in a less than one percent range between 2.2 and 2.8 percent growth – hardly the jump that would be expected from a sub-4 percent unemployment rate.

This begs the question – which part of the equation is broken? Employment has been consistently improving since 2009; when the unemployment rate reached 10 percent. The same trend can be seen in the more narrow measure of labor force that focuses on part time job growth. In the past, a divergence in these two measures would call into question the quality of the prevailing employment picture but that doesn’t seem to be the case. One employment trend that has emerged is the rise in service jobs versus traditional manufacturing jobs. However, the global economy has evolved and thanks to demographic trends, technological innovation, and the “gig” economy this is not a surprise.

So, it must be the wage portion of the equation? This seems more likely for some, but not all, of the aforementioned reasons:

Technology is often scapegoated as the term is broadly interpreted as “automation”. The automation argument may be true in some cases. In fact, we enjoy new efficiencies in everyday life as we travel through the airport or order at a restaurant. However, a slew of high wage jobs are required to develop the new technology to automate away less skilled workers. Ultimately, this may put upward pressure on wage costs.

Demographics or the “juniorification” of the workforce. The “baby boom” generation has earned a break and it is time to enjoy the fruits of their labor. According to the Pew Research Center, Millennials (20-35 years old) are projected to overtake the Baby Boom (52-72 years old) as the nation’s largest living adult generation in 2019. As the older generation “passes the baton” of responsibility it is very unlikely that they are passing the salary and benefits packages that came with it in the past. In today’s world companies are looking to save costs in every area. They no longer offer expensive defined-benefit pension plans and high-deductible health plans are becoming the norm, to cite just two examples.

CH1_GenerationsBirths_projected

The “Gig” economy refers to the new class of workers that chose lifestyle over the traditional work environment (i.e. Uber). This group includes people that work at will and as needed. Participants in the “gig” economy set their own schedules, work as frequently (or infrequently) as they want and are responsible for their own overhead costs (insurance etc.). So while they are “employed” this remains a very difficult cohort to quantify.

Ultimately, it still remains to be seen whether the perpetually low rates of the last ten years can spur inflation. Regardless, the sound underpinnings of the domestic economy provide a supportive background for the Federal Reserve to continue on a measured path of interest rate normalization. While we don’t claim to know if or when real inflationary pressures will surface, we continue to closely monitor a number of indicators for the telltale signs.

Authors

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Ryan Driscoll is responsible for trading, investment analysis. He is a member of the Treasury Solutions team since its inception. Ryan is an active participant in the investment and rebalancing process, manages the quarterly reporting process and is actively engaged with Treasury clients. Prior to joining Commonfund, Ryan worked at Sailfish Capital Partners, a multi-strategy fixed income fund, where he served on the Emerging Markets team. Prior to that, he was on the fixed income team at Grantham, Mayo, Van Otterloo & Co. and was an equity/fixed income trader at Loring, Wolcott and Coolidge, in Boston. Ryan received his B.S. in Finance and M.S. in Global Financial Analysis (with Distinction) from Bentley College. He is a CFA Charterholder and is a member of the Boston Securities Analyst Society and CFA Institute.
Ryan Driscoll
Director, CFA
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Kristofer Kwait is Deputy Chief Investment Officer, and Head of Investments responsible for leading the marketable equities, fixed income, hedge funds and real assets investment teams as well as analytics. Prior to his current role, Kris was head of the Hedge Fund Strategies Group. Previously, he served as head of hedge fund research with responsibility for overseeing the design and implementation of proprietary models for manager selection, portfolio construction, and risk management. Before joining Commonfund, Kris was a proprietary trader at both Andover L.L.C. and A.B. Watley, where he managed relative value equity strategies. Prior to his experiences as a trader, he was a stockbroker at Smith Barney. Kris attended pre-college at Juilliard School of Music, has a B.S. from Purdue University and an M.B.A. from the Yale School of Management.
Kristofer Kwait
Deputy CIO and Head of Investments

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Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.