Much as Narcissus ruinously fell in love with his own reflection, economists shouldn’t fall in love with their own graphs. But given how revealing the little figure below is, I’m willing to take that chance.
The figure couldn’t be simpler. It plots recent monthly unemployment rates against the recent growth rates of nominal, hourly wages, year over year, for middle-wage workers. The figure covers 2014-2018, a period when the unemployment rate fell from about 6.5 percent to less than 4 percent. The smooth line plots a nonlinear path through the dots to facilitate interpretation.
The figure shows that it takes very low unemployment to generate wage gains for middle-wage workers. (The same holds for low-wage workers, though for them, the minimum wage matters a lot, too.) Over these years, going from 7 to 6 to 5 percent didn’t do much at all for these workers. In fact, as the little dip in the smooth line shows, wage growth was actually a bit slower when unemployment was 5 to 6 percent than when it was 6 to 7.
But when unemployment starts to close in on 4 percent and lower, good things start to happen, and the smoother line must head north to cut through the dots.
The mechanism behind this relationship cannot be reduced to simple supply and demand. If that were the case, then going from 7 to 5 percent unemployment would do more than it does for wage growth. The key factor in play here is something you don’t hear enough about in most economic discussions, even though it’s a key determinant of wage growth: worker bargaining power. Middle- and low-wage workers in this country suffer such acute bargaining power deficits that only at persistent, chock-full employment will employers be forced to bid up wage rates.
Part of the power problem is diminished unionization; part of it is increased employer concentration, allowing a few dominant firms to set wages in their industries; part of it is a political agenda that has been hostile to workers and embracing of finance, high-end tax cuts, eroding labor standards, fissured workplaces and deregulation.
Those are a lot of head winds, but, remarkably, full employment still works as a tail wind against them all, but only at very low levels of unemployment.
The question is, can the U.S. economy sustain such low levels of joblessness? Isn’t this a recipe for economic overheating and inflation? There were clearly times in our economic history when low unemployment pushed up wage growth, which, in turn, bled into faster price growth. But there has been a lot less of that in recent decades.
Over the period covered by the figure (2014-18), the Federal Reserve’s preferred inflation gauge rose from about 1.5 percent to 2 percent. That’s an increase, but not much of one, and it merely brings inflation to the Fed’s 2 percent target. For whatever reason, employers paying higher labor costs haven’t been passing those costs forward to consumers as much as they used to.
This has two implications. First, it implies that higher labor costs could take a bite out of business profits. If so, that’s a good thing from my perspective (though the stock market disagrees), as the profit share of national income has been historically high in recent years (and labor’s share has thus been low). Second, and this is a particularly interesting potential result, employers finding themselves in an unusually high-pressure labor market may be forced to find efficiency gains to offset the higher labor costs, especially if they’re unwilling to raise prices very much. Why, if they could find such gains, did they not do so earlier? Because weak worker bargaining clout at higher unemployment rates meant employers didn’t need to raise pay and, thus, didn’t need to be more productive to maintain their profit margins. Now, they either discover those efficiencies, pass on price increases or face smaller profit margins.
If I’m right about this dynamic, it creates a critical linkage between tight labor markets, rising wages, and faster productivity growth, the latter of which has been notably missing from the U.S. economy in recent years.
Now, for some caveats. One graph of two variables over a few years can’t possibly say that much about how economies work. Thankfully, however, a lot of other evidence supports this relationship; very low unemployment boosts pay, and much more for middle- and low-wage workers than for high-wage earners. Second, these are nominal wage gains, when real inflation-adjusted wages are what’s most important to working families. But I’ve got good news there, too. Given the recent decline in energy prices, top-line inflation has slowed, and I predict real wages for these workers will be up 1.3 percent in 2018. That may not sound like much, but for full-year workers, it’s an extra $600 per year.
Perhaps the most important question is how long will such favorable conditions last? Part of that is up to the Federal Reserve, as it has the power to slam the brakes on the economy with aggressive interest-rate increases. It is worrisome, in this regard, that the Fed believes the lowest unemployment rate consistent with stable inflation (4.4 percent) is considerably higher than today’s 3.9 percent. However, to their credit, many Fed officials, notably Chairman Jerome H. Powell, recognize that economists simply cannot reliably estimate this “natural rate.” The fact that central banks used to believe the natural rate was 5 to 6 percent is one reason that middle-class real wages have seen so little growth in recent decades.
The other wild card is, of course, crazy politics. With the trade war and government shutdown, the Trump administration is repeatedly kicking the ball in its own goal. It should stop doing so, but it won’t.
So, while I hope current conditions will persist, the truth is that such low unemployment has been the exception, not the rule, for much of the past 40 years. My fervent hope is that the story told by this little graph inspires policymakers to work to change that reality over the next 40 years.