Beware of the US-Centric Inflation Hysteria?
“Fed officials do not believe that wage pressures can exist in a world with 6% unemployment, so they are in full denial,” Stephen Stanley, chief economist at Amherst Pierpont Securities LLC, said in a note. “A substantial pickup in wage gains would be the quickest path to turning a ‘transitory’ inflation blip into a persistent upturn.”
Indeed, a substantial pickup in wage gains would be the quickest path to turning a ‘transitory’ inflation blip into a persistent upturn.
Why? Because higher wages allow people to spend more on goods and services and could cause a wage-price spiral similar to what we saw in the 1970s:
The idea is that higher wages spur more spending growth that strains production capacity and drives up business costs. In turn, companies raise prices and workers demand even larger pay increases to stay ahead of a rising cost of living.
But are we really on the cusp of a wage-price spiral? David Rosenberg doesn't think so:
Inflation watchers are interested in wages because it is the proverbial canary in the coal mine. Excessively high inflation has historically been accompanied by accelerating wage growth, over and above the trend in labour productivity.
It’s true that between 1992 and 2000, wage growth picked up without a corresponding increase in actual inflation. But that was a period during which the U.S. dollar was surging, keeping import prices (and hence overall inflation) under wraps. So, could we have another wage-driven inflation spiral à la late 1970s/early 1980s?
The latest data do not suggest an acceleration in the pace of nominal wage growth (and at a time when measured productivity is picking up at an even faster rate). And here we are talking not about hourly earnings data from U.S. employment reports which, as we have seen over the past year, can be distorted by composition effects as employment of lower paid workers fluctuates. Instead, we’re referring to the Atlanta Fed’s Wage Growth Tracker, which tracks reasonably well the private sector wage component of the Employment Cost Index and measures the growth of wages of the same group of workers over 12 months, making the measure less susceptible to compositional changes. According to that measure, wage growth seems to be levelling off at less than four per cent year over year.
Why Is Wage Growth Sputtering?
The loss of momentum for wages should come as no surprise considering still-significant amounts of slack in the labour market. While employment rose for the fourth consecutive month in April, there are still nearly 10 million Americans who are out of work. But looking beyond obvious cyclical factors, it is clear that structural forces continue to weigh on wages. Recall that towards the end of 2019, i.e., when the labour market was booming and the broad unemployment rate was near all-time lows, wage growth remained stuck in the three-to-four-per-cent range.
Back in 1999-2000, a similarly tight labour market generated much higher wage growth. Some will blame accelerated globalization, which moved up a gear in 2001 as China joined the World Trade Organization. Others will point to even earlier trends such as the decline in unionization rates — the employment share of union members has dropped by half since 1984 — which continues to limit workers’ bargaining power.
The level of skills/education may also be affecting the extent of wage growth. Research from the Atlanta Fed shows that wage growth after a period of unemployment tends to be positively related with education. The same research concludes that less educated workers face a double whammy in the sense they are more likely to lose their jobs and also experience slower wage growth once they return to employment. This is exactly what the U.S. labour market is facing over the next year or so, considering most of the job losses during the pandemic were experienced by less educated employees.
Also note that the pandemic has hurt part-timers (whose employment is down 10 per cent since February 2020) more than those with full-time positions (down less than five per cent). As such, the return to the labour market of part-timers (who also tend to earn less than full-time workers) is likely to keep a lid on overall wage growth in coming quarters.
If Wage Growth Does Accelerate, Will There Be an Inflation Surge?
While the outlook for wage growth is not exactly rosy, let us assume for a minute that firms suddenly feel compelled to dish out raises to workers. And here we are thinking of transformative policies by Congress to strengthen worker bargaining power e.g., increasing wage transparency, reducing the use of non-compete contracts, and reducing labour market monopsony.
Would the resulting wage growth necessarily spill over to product markets and cause inflation to surge?
Not necessarily. Historically, firms tend to pass on higher costs to consumers when wage growth outpaces productivity growth. There is indeed a clear positive correlation between the annual core inflation rate and the wage-productivity differential.
Could that happen this year or next?
The good news is that cost-push inflation looks to be under control, with productivity growth significantly outpacing wage growth in recent quarters. It may be too early to assert with complete confidence that we are seeing a structural shift upwards in productivity, but latest data is showing a discernible breakout in trend (incredibly, to more than a four-per-cent rate at the moment).
Rosenberg isn't the only one thinking that rising wages won't translate to higher inflation.
In his Barron's comment, Matthew C. Klein also notes even if wages surge, inflation won't necessarily follow:
American businesses are posting far more job openings than ever before, workers are quitting at the highest rate on record, and wages for nonsupervisory employees at restaurants, bars, and hotels are currently rising at an annualized rate of more than 20%. That’s why, even though nearly 10 million Americans remain underemployed, many people—from former Treasury Secretary Larry Summers to Republican Senate leader Mitch McConnell—are worrying that a hot job market could lead to accelerating consumer price inflation.
While it’s certainly possible that workers flush with cash might bid up the prices of goods and services if consumer demand persistently exceeds what businesses can produce, there are two reasons why investors should be wary before betting on a sustained period of out-of-control inflation.
First, despite a few anecdotes here and there, worker pay isn’t actually rising at a faster pace than before the pandemic.
The average employed American earned about $30.33 an hour, up from $28.51 before the pandemic. That’s an annualized growth rate of 5.1%, up from a prepandemic average growth rate of 3% a year. But the surge isn’t because workers got big raises. While some did, the bigger explanation is that most of the people who lost their jobs weren’t paid much to begin with. That automatically lifted the reported average wage of anyone who still had a job, even if most individual workers weren’t any better off.
Just look at the wage growth tracker published by the Federal Reserve Bank of Atlanta, which looks at the individual changes in wages of a large sample of workers. The median change in wages tends to track the share of workers ages 25-54 with a job, although the pace of pay increases has consistently been about 3% to 4% since the beginning of 2015. From the end of 2018 until the pandemic hit, wages had been rising at the faster end of that range. Since then, pay growth has decelerated to just over 3%.
There’s also the Employment Cost Index, published by the Bureau of Labor Statistics, which accounts for changes in the mix of workers as well as changes in benefits and bonuses paid. This measure of pay is up just 2.6% over the past 12 months—slightly slower than before the pandemic, and substantially slower than in the years before the financial crisis. Companies’ labor costs could rise meaningfully in the future, but they haven’t done so yet.
Second, even if worker pay does accelerate in the future, the link between wages and prices is too weak to be a reliable harbinger of faster inflation.
For one thing, the mix of things Americans buy is different from the mix of industries in which they work and earn money. About one out of every seven consumer dollars is spent on groceries or food services, but less than one out of every 20 dollars earned in employee pay goes to people who work in agriculture, food manufacturing, grocery stores, and restaurants. Less than 7% of America’s total wage and benefits bill is paid to workers in construction and real estate, but more than 16% of spending goes to housing. Meanwhile, a large chunk of America’s total employment income comes from sectors that aren’t consumer-facing at all, such as the government, law, investment banking, B2B software development, advertising, and management consulting.
More generally, while labor is the biggest cost for the economy as a whole, wages are only one expense for many individual businesses alongside rent, capital equipment, raw materials, components, professional services, and electricity. When companies cut those other costs through efficiency improvements and productivity growth, they gain the space to pay their workers more without having to raise prices. That’s how wage growth accelerated throughout the 1990s even as inflation slowed down.
The flip side is that price spikes can happen even when wages are flat if businesses feel compelled to pass along higher input costs to consumers. Car-rental companies didn’t lift their prices by 62% since last February because they ran out of workers, but because they had liquidated their fleets in the spring and were unprepared for the snapback in demand. Those same companies are also desperately bidding on used vehicles at auctions, further pushing up inflation in excess of most workers’ wage gains.
Then there’s the flexibility of profit margins. Companies worried about retaining workers may eat into their earnings if they lack pricing power, while businesses with market dominance may raise costs for consumers without passing on any gains to their workers. The bargaining power of labor isn’t constant across time or industries, which further weakens the link between wages and prices.
There is one way that accelerating wages could lead to faster inflation, and that’s if the boost in incomes leads to a sustained surge in consumer demand that pushes businesses to raise prices. Something like that started in the mid-1960s—and it lasted until the deep downturn of the early 1980s crushed both wages and inflation.
The good news is that’s unlikely to happen again, in part because any uptick in wage growth after the pandemic, if it happens at all, is going to coincide with a sharp tightening of fiscal policy that should limit the total increase in consumer spending power. There won’t be another round of $2,000 checks going out again soon, and enhanced unemployment benefits are set to turn off nationwide in a few months.
The Hutchins Center at Brookings estimates that changes in government spending and taxes boosted the U.S. economy’s growth rate by six percentage points in the past four quarters. Fiscal policy is projected to subtract more than two percentage points each year in 2022 and 2023 as support is withdrawn.
No wonder broker-dealers and other investment professionals are unconcerned about the risk of excessive inflation over the next few years—a sentiment that’s also evident in market pricing of inflation derivatives. Instead of worrying about accelerating wage growth, investors may want to focus on what could happen if worker pay fails to speed up in the years ahead.
You can read another great comment on the case for and against worrying about inflation here. It too explains why wage pressures will likely ease this fall:
America’s unemployment rate remains near 6 percent. Wages are rising, but not to any remarkable extent. The pre-pandemic era was characterized by tepid wage growth and record corporate profits. Thus, there’s reason to think that pay rates can rise quite a bit further without triggering massive price hikes, as labor secures a less-flimsy share of the value it produces.
In any case, the main driver of workers’ present bargaining power — the $300-a-week federal unemployment benefit — will disappear come October. The American labor movement remains exceptionally weak. Tight labor markets could put some upward pressure on wages. But the era in which large portions of the workforce enjoyed the benefit of collective bargaining agreements with cost-of-living adjustments — such that any increase in prices would automatically increase their pay — is long dead.
But while not everyone is convinced that sustained wage increases are on the horizon, some economists are sounding the alarm.
Late last month, the Lindsey Group put out a comment on declining real wages:
Earlier this month, the Bureau of Labor Statistics reported that while average hourly earnings rose 0.9 percent in the first four months of the year, prices (CPI) rose 2.1 percent—meaning real wages fell 1.2 percent in four months. That is a 3 ½ percent decline at an annual rate. Not even the growth in employment was sufficient to overcome inflation, from a macroeconomic point of view. Non-farm payrolls have risen 1.2 percent in the last four months, meaning there has been zero real growth in total employee compensation.
Declining real average hourly earnings have been unusual over the past forty years. Last year, real average hourly earnings rose (in part due to a mix-shift) by 4.2 percent. They averaged 0.9 percent annual gains in the preceding three years and 0.375 percent increases in the eight years before that. Generally speaking, real average hourly earnings only decline in recessions because nominal wages exhibit little growth or may decline. That is not the case this time. The culprit now is accelerating inflation, something the economy hasn’t experienced in a long time.
One must look back to periods of rapidly accelerating inflation to see this phenomenon empirically. In those instances, price increases tend to happen in advance of wage increases because the labor market is slow to adjust. In general, workers only get large wage increases when they change jobs. Workers staying in the same job get a year-end raise that includes an adjustment for price increases over the previous year. But when inflation is accelerating, an adjustment for last year’s price increases in this year’s paycheck just doesn’t cut it.
Stated in macroeconomic terms, accelerating inflation begins as “demand pull” and then later turns into “cost push.” Today, the economy is certainly undergoing demand-pull inflation as extremely loose fiscal policy coupled with highly accommodative monetary policy is pushing a rapid increase in nominal GDP. As the economy approaches capacity, most of that extra growth becomes inflation. As employers and their employees become accustomed to this accelerating inflation, workers tend to demand increased compensation. This raises costs, most of which are passed on to consumers (who are also now more accustomed to taking price increases). Once that happens, the economy no longer needs excess demand to have inflation—the psychology of rising inflation expectations becomes a dynamic unto itself.
The data also make an overlooked point about the labor market. Falling real wages hardly make for an auspicious background to attract people back to work or even back into the labor force. Of course, this is on top of the existing disincentives from transfer payments. But it is unlikely that the labor force participation rate will return to pre-pandemic levels until real wages start rising again. The “inability to find qualified applicants” to fill vacancies does have a price component, though it is unclear just how elastic the supply really is; elasticity of labor supply is never great and given current conditions our best guess is 0.2. On that assumption, it would take a 14 percent increase in real wages, largely in the bottom half of the wage distribution, to get labor force participation back to pre-pandemic levels. That would guarantee cost-push inflation.
There is also a demand-side issue. Falling real wages ultimately means falling real Personal Consumption Expenditures (PCE). For now, transfer payments are sustaining total real disposable personal income. Without them, real PCE will be sharply lower. This is one reason we think incumbents will approve another round of stimulus checks to go out early next year.
One can also make a normative conclusion about policy. Rising real wages are a cornerstone objective of economic policy; the current policy mix is failing on that front. Demand is rising much faster than supply can manage. Given the lags in wage adjustments in the labor market for workers remaining in their current jobs, this situation is likely to persist for some time. The longer inflation continues, the more painful the ultimate adjustment will be.
There is definitely a lot to think about when it comes to wage inflation but I will note this, as long as real wages are declining, it caps any rise in inflation expectations.
Shifting my attention to markets, this week Francois Trahan and his team ask What if the Fed is Wrong About Inflation?:
Take the time to read Francois's full comment here, it's excellent.
In his weekly market wrap-up, Martin Roberge of Canaccord Genuity notes this:
Our focus this week is on bond yields and the growing disconnect with accelerating inflation. So far, the Fed is not letting go of the transitory inflation argument. We hold a different view, with our inflation gauge calling for above-target price increases through H2/21 and cost-push inflation dynamics likely playing out in H1/22. Aside from the transitory/persistent debate, the system is awash with liquidity, with banks holding unprecedented amounts of reserves. Hence, demand for reserves is waning while supply remains abundant. This, we believe, explains the downward pressures on short-term rates near the 0% floor. Meanwhile, the central bank is busy mopping up T-bonds and T-bills through its bond buying program. Connecting the dots, this likely explains why reverse repo operations are skyrocketing, with market participants handing their cash to the Fed in exchange for collateral (T-Bonds and T-Bills). Collateral scarcity led to a decline in bond yields despite rising inflation fears. As we show in our Chart of the Week, real interest rates in the US have plunged to 40-year lows. We view these factors as temporary, with the Fed likely to tackle the issue by raising the reverse repo rate and/or the IOER and eventually tapering its QE program. In the end, above-target inflation should beget higher bond yields.
Recall, last week, I stated the Fed is already tapering, draining $485 billion in liquidity via reverse repos, undoing four months of QE. It's just keeping hush about that but market pros are paying attention.All this to say, I'm skeptical that yields will resume their uptrend any time soon, and I'm increasingly worried about global deflation.
For the month of May 2021, China’s General Administration of Customs believes the total US$ value of exports exiting that country was an impressive-sounding $263.9 billion. Compared to the US$ value of exports sent abroad in May 2020, this was a 27.9% increase. But base effects; exports in May 2020 had been a little more than 3% below those in May 2019. The 2-year change, therefore, a less inspired 11.1% compounded.
This suggests China’s vast export sector has been bumped up no more than it had been a few years ago during the insufficient top of Reflation #3. And that’s with everything being thrown into this global goods rebound largely emanating from the US; from rare earths to PPE stuff, a lot of one-offs have been included just to get to that $263.9 billion.
Furthermore, those same had stacked up much higher all the way back in December 2020. The GAC doesn’t seasonally adjust its figures, yet there’s still a recognizable seasonal pattern in them. The jump in last December’s export levels still represents the most recent peak. In other words, five months into 2021 the latest data continues to indicate how that may have been the best it gets for the rebound.
What if it really is downhill from here?
Before thinking about that, there’s still China’s import side to consider. Over here, the annual number is even more impressive, nearly twice the growth shown in exports. Rising 51.1% year-over-year last month, like all the rest of Chinese estimates (ex exports) these are huge numbers which otherwise appear to indicate a robust, intentionally government-fueled economic recovery consistent with what’s said to be behind 1970s-style inflation numbers at least in the United States.
The 2-year change in imports, though, this was only 12.4% (compounded) which doesn’t even come up to the better levels of Reflation #3. Even all that’s supposedly going right in and around China via global trade and the mainstream view of its internal policy contributions, the best they’ve managed (so far) from the inside is importantly less than what wasn’t nearly enough for the global economy heading toward 2019’s more synchronized global downturn (and eventual recession).
Why isn’t it going so much better, so much less ambiguously?
Two questions that combine to give us a data-side view of the post-Feb 24-25-26 anti-reflationary marketplace; a widespread global anti-reflationary marketplace (the only reflation trading in bond markets has been Europe). While the media in the United States can’t get enough inflation talk, bonds around the rest of the world have actually pulled in those from the US lining up more negative answers to those two enquiries.
If December 2020, or thereabouts, does present the possible top of the 2020 recession rebound, it also would mean peaking well short of anything like a full and complete recovery. Reflation that in comparison to past reflationary periods (considering the huge downside/contraction from which it began) comes up even less than those would account for bond yields behaving as they have in equal part short- as well as longer run considerations.
It’s not just Chinese trade terms nor limited to global trade across regions. China’s economy as a whole continues to exhibit the same signs in both these dimensions, only starting with its near-term top somewhere around the end of last year and the beginning of this year (despite when reflation yields really picked up). The other perhaps more important element being just how little that possible peak may have reached.
These possibilities are captured only-too-well by these various 2-year comparisons – including overall nominal GDP in RMB (IOW, it’s not just US$ trade terms which indicate shrinking possibilities as well as growth). This measure, unlike estimates of real GDP, is less susceptible to artificial (read: political) influences or even targets.
The correlation between nominal China GDP and marginal export changes has been a very strong one, as anyone would suspect given how the Chinese system remains wedded to its export sector (realizing how in reality rebalancing is a hope or wish rather than rational analysis or design). Nominal GDP had leapt 21.2% in Q1 2021 when compared to the recession-stricken quarter of Q1 2020.
Already you see their problem – in the first quarter of 2011, by comparison, after more than a year of what had been “recovery” from the world’s Great “Recession” that for China, anyway, wasn’t nearly as rough as it had been last year, the 2-year change was 18.8% compounded annual.
In Q1 2021, by contrast, the 21.2% one-year change followed what had been a nearly 7% decline last year for a two-year total of barely 7%. Nominal. Bigger decline, actual decline, half the recovery speed? And half for an entire year now.
Nominal 2-year expansion has pretty much stuck around this number for each of the four quarters since the contraction (only the smallest, most suspicious of acceleration: from 5.4% 2-year in Q2 2020 to 6.3% then 7.0% and now 7.1%). It’s hardly the roaring comeback otherwise pictured when peering through the highly colored lens of US goods or the equally distortive filter of 1-year base effects.
This is substantially less, significantly slower from China than even 2018 and 2019 when the “world” had been shocked to see such stubborn negativity posted by this crucial economic nexus. As always, depending upon the Chinese for marginal growth has – since 2011 – been a difficult and ultimately losing proposition.
This does not appear to have changed in the aftermath of 2021; if it has, to this point it has only been a change in the sense of yet another longer-term downshift in results therefore very likely potential (a possibility only strengthened all the more by words and behavior of Chinese officials).
There has been this ongoing perception, the very one underneath all the inflationary hysteria, that the frenzy in the US goods economy is representative of conditions first in the rest of the American domestic economy as well as for the entire worldwide system. In truth, as we see time and again in foreign figures – China most of all, a huge marginal chunk of any growth/anti-growth period – the US goods economy isn’t just an outlier it is an extreme one.
The vast majority constituting the rest is really struggling.
The view instead from China, consistent with that vast majority, is a very lackluster return from the depths and one that may just have reached its fullest if disappointing speeds already some time ago. This, along with money/liquidity risks epitomized by Feb 24’s Fedwire disruption and its Feb 25 impact on UST liquidity, would more than begin to explain the changing bond viewpoint.
Dealing in probabilities, it would then make perfect sense why global yields which had previously sprung suddenly into reflationary trading almost as suddenly jumped right out of them. Or, more specifically, balance of probabilities that had been more favorable after last November, risks tilting toward a limited reflationary upside, tilted right back down again and remain steadfastly lower the longer it goes and the more China (and the rest of the world) fails to converge with US goods – despite having been artificially buoyed by that frenzy in US goods.
And if the US goods economy converges with everything else, as we keep asking, then what?
Whatever these increasing downside possibilities, which doesn’t necessarily mean more contraction or outright negatives ahead, the one thing they don’t contain is actual inflation either for the rest of the world let alone the United States. None of this, however, will do much to sway the sure-to-be even more colorful interpretations of this week’s May US CPI figures.
In fact, while there's clearly some cyclical inflation going on in the US, most of it is transitory and my fear is that too many people are paying attention to it without looking at what is going on in the rest of the world, especially China.
If Snider is right, this time next year, we might be talking about deflation again, not inflation.
Alright, let me wrap it up there, you have plenty of food for thought on inflation here.
Below, Manpreet Gill, head of fixed income, currency and commodities strategy at Standard Chartered Plc, discusses the market implication of inflation concerns, and the opportunities he sees in global markets. He speaks with Rishaad Salamat and Haslinda Amin on "Bloomberg Markets: Asia."
Also, CNBC's Jim Cramer discusses the latest inflation number from the Labor Department reveals why the Federal Reserve is keeping interest rates low.
Lastly, earlier this week, Stephanie Link, chief investment officer at Hightower, discussed how the Fed may react to this week's inflation data, and what parts of the market you may want to be in right now.