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Fear not faster wage growth (which isn’t here yet, but may be coming)

Source: See data note below
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The blue line in the figure above shows nominal wage growth — before accounting for inflation — since the early 1980s (see note below for info on the data). It’s gone up and down roughly with the business cycle (recessions are shaded), though in the current cycle it’s been pretty flat, stuck at an historically low rate of around 2 percent. And yet, the job market is tightening up, and unemployment, at 5.3 percent, is almost at the Federal Reserve’s “natural” rate — the lowest unemployment rate they believe to be consistent with stable inflation (5.1 percent).

This piece from Vox explores the same question, with links to employers across the land claiming that they’re “struggling to recruit” the workers they need. By the logic of supply and demand, shouldn’t that lead to higher wage offers?

That’s obviously possible. In a sec, I’ll show you a model that in fact predicts faster wage growth right around the bend, assuming the job market stays on track. But the point I want to make here — one that I’d argue is under-appreciated — is that it’s not just faster wage growth that matters, it’s how much faster.

Too often — and you see this in the inflation debate, too– there’s a sense that as soon as wage growth (or price growth) accelerates, it’s time for the Federal Reserve to step in and stop the party. But as Federal Reserve chair Janet Yellen herself has averred, that’s not the way it works.

In theory, for average wage growth to create inflationary pressures, it has to grow faster than the sum of the Fed’s inflation target plus the underlying rate of productivity growth. Yellen has put that at 3.5 percent — the Fed’s 2 percent inflation target plus 1.5 percent productivity growth.

Now, check out the smooth line in the figure. That’s predicted wage growth based on a model described in the data note below. The key variable in the model is a comprehensive measure of labor market slack derived by economist Andy Levin (it accounts for unemployment, underemployment and the gap in labor force participation). The model’s not perfect, of course — wage growth is generated by a lot of moving parts — but it tracks the underlying series well and catches the turning points.

By assuming that the job market will continue to tighten at its recent pace, I can plot the trajectory of wage growth through 2017. According to the model, wages continue to accelerate, but by the end of the forecast, they’ve still not hit Yellen’s 3.5 percent target. The last observation — 2017q4 — is 3.2 percent.

That’s a lot of years of subpar wage growth, though since inflation’s been so freakishly low lately, there’s been more real wage gains than would prevail at normal rates of price growth (real hourly wages are up about 2 percent over the past year, the same as nominal wages, implying an inflation rate of about zero). In fact, given the extremely weak performance of compensation over this recovery, we’ve seen another phenomenon that’s germane to this story: the decline in the share of national income that comes from paychecks, and the commensurate increase in the share that comes from profits.

That’s a problem in and of itself, emblematic of rising inequality, and a reminder of who’s been benefiting from growth in recent years. But how does it relate to this discussion of the how fast is too fast when it comes to wage growth?

Here, we need to turn to recent work by economist Josh Bivens, who, in a paper for the Center on Budget’s full employment project, makes a key point unifying these various threads — weak wage growth, the fall in labor’s share, the role of the Fed in managing these developments. Josh explains that to rebalance labor’s share of national income, average compensation must exceed the Fed’s 3.5 percent benchmark for a while.

He gives you the math, but it’s pretty intuitive: When average wages grow more slowly than average growth, labor share contracts. There needs to be some catch-up (or as Bivens puts it, “clawback”).

How much? The figure below from Biven’s piece shows that depending on how much average wage growth exceeded 3.5 percent, it would take five to 14 years (!) to nudge the labor share back to its pre-recession peak.

But wouldn’t that be inflationary?! No! It would be “paid for” out of a shift from profits to paychecks, which is precisely what the doctor ordered, if you ask me.

So fear not wage growth. Fear not faster-than-average wage growth. If you want to fear something, fear the lack of wage growth. In fact, all this talk about averages ignores the fact that groups with lower-than-average wages depend on a really high-pressure job market to see anything in the way of real wage gains. Those who depend on their paychecks, which is most working-age people, have a lot of catching up to do.

Data note: The wage series uses principal component analysis to combine five different wage/compensation series, including median weekly earnings, average production worker hourly wages, two measures from the Employment Cost Index, and one from the productivity data. The model regresses the annual percent change in combined index on the slack variable and two lags of the dependent variable. The forecast allows the slack variable to decline at its same rate of the past two years until it hits zero (full employment by this measure) in 2017q3. Want to play with these data yourself? Go right ahead!