Wages and Inflation Expectations - August 2023 Update
Wage growth outpaces easing inflation expectations and continues to overshoot the pace consistent with the Fed's inflation target.
In a recent note I laid out a simple framework that can be used to interpret wage growth trends relative to inflation expectations and the Fed’s inflation target. this and can be used to inform us about the U.S. economic outlook. The resulting W* measure reflects a trend wage growth rate where demand and supply in the labor market are in balance when expected real wages equal trend labor productivity growth.
With new wage data for July, labor productivity data for Q2 and updates of inflation expectations data for July and August, this note will update the above-mentioned wage growth framework. Key takeaways:
“Main Street” inflation expectations eased further but remain above target with tentative signs that most of the downside adjustment is behind us.
Trend wage growth (W*) eased further, mainly in line with inflation expectations, suggesting more wage growth easing could be forthcoming.
Nonetheless, W* remains consistent with 3.2% PCE inflation, above the Fed’s 2% inflation target. So, any actual further wage growth easing in line with this measure would still keep wage growth at an above-target pace.
Corrected for expected inflation and trend productivity growth, wage growth is now a main boost for households’ real incomes and spending.
Inflation Expectations
To construct the W* trend wage growth measure, I focus on inflation expectation surveys drawn from “Main Street”, i.e., five inflation expectations samples from households and firms. Since the last note, four out of these surveys got updated with July now being complete and two surveys providing expectations for August (the University of Michigan Survey on Aug 11 and the Atlanta Fed survey on Aug 16). As explained in my original W* note, these inflation survey measures are aggregated by means of a single dynamic common factor that depends on its own lag using the approach of Banbura and Modugno (JAE, 2014).
The updated individual expectations series are plotted in the chart below alongside the updated, estimated common factor across these series. After scaling the factor in year-on-year PCE inflation terms, inflation expectations got revised down for July from an initial 3.5% to about 3.2%. The preliminary estimate for August currently suggests that inflation expectations might be stabilizing around 3.2%.
Trend Labor Productivity Growth
The release of the BLS's "Productivity and Costs" report for Q2 garnered a lot attention, as quarter-on-quarter labor productivity growth bounced back substantially in Q2 relative to Q1. After updating my own estimate of trend labor productivity, the revisions relative to the Q1 vintage of data are minimal: year/year trend labor productivity growth for Q1 was revised up from 1% to 1.15%. Underlying trend labor productivity growth therefore remains subdued historically, as the chart below makes clear.
Wage Growth
I now combine the following two ingredients,
The trend productivity growth estimate described earlier (assuming a Q3 trend labor productivity level based on the average quarterly trend productivity changes over the past 4 quarter, followed by linear interpolation from the quarterly to the monthly frequency).
And, either the year-ahead inflation expectation proxy based on the common factor from surveys or the 2% inflation target.
This will result in two alternative trend wage (W*) measures, and I compare these in the chart below with Atlanta Fed wage tracker wage series that measure average hourly wages of workers that are robust to compositional changes.
Compared to last month, the chart continues to suggest that heading into 2023 wage growth started to overshoot the expectations-based W* metric, suggesting positive expected real wage growth throughout the first half of the year as well as going into Q3. Note, though, that both actual wage growth as well as the expectations-based W* measure remain still above a level that is consistent with the Fed’s 2% inflation target and are more consistent with 3%-4% PCE inflation rates.
Implications
The 2023 overshoot of wages relative to expectations-based W* in the chart above is partly driven by the decline in this W* as inflation expectations eased further throughout the year. This is in itself a good trend for the Fed, as the downward move in this W* suggests that a continued easing trend in wage growth could be possible for the remainder of the year. This trend wage growth, however, is consistent with an above-target 3% inflation rate. And data on inflation expectations tentatively start to suggest that the bulk of the downward adjustment in expectations might be behind us, providing a floor under how much trend wage growth will be likely to ease further.
The positive expected real wage growth rate seen throughout 2023 up to now, likely will boost expected real wage incomes of household. This will keep consumption at robust levels, and with the ongoing rotation of consumption back to services this could in particular result in upward pressures in core services prices to persist. In turn this could keep inflation expectations at above target levels and, thus, the rate of trend wage growth.
On the other hand, higher real wage growth this year will increase the inflation-adjusted cost of labor hoarding for firms. Combined with higher non-labor input costs and more expensive credit lines, firms might decide at some point in the back half of 2023 to start slashing labor costs by significantly reducing these labor hoarding levels. The resulting labor market easing then could alleviate some of the wage growth pressures seen today.
It is this interplay between possible consumption spending boost and potential firms’ labor cost slashing outcomes that could be a major driver for the Fed’s behavior going into 2024. Hence, the Fed will remain especially sensitive to continued easing in labor market tightness. A lack of progress on this over the next 2 to 3 months will make it unlikely that the Fed will contemplate easing its monetary policy stance anytime soon.