Wages and Inflation Expectations - December 2023 Update
Wage growth rates still easily outpace the Fed's inflation target consistent rate, while inflation expectations eased to about a 3% PCE inflation equivalent.
Earlier, I laid out a framework that can be used to interpret wage growth trends relative to inflation expectations and the Fed’s inflation target. The resulting W* measure reflects a trend wage growth rate where demand and supply in the labor market are in balance given an inflation outlook. It is equal to either the 2% inflation target or year-ahead inflation expectations plus a trend labor productivity growth estimate as well as a trend labor share growth estimate. The latter component corrects my original W* for long-run shifts in workers’ compensation as a share of non-farm business sector revenues (a.k.a. the labor share).
With new wage data for November, revised labor productivity and labor share data for Q3 and updates of inflation expectations data for November and December, this note will update the above-mentioned wage growth framework.
Key takeaways:
Between July and October “Main Street” inflation expectations have been stuck around a 3.2% PCE inflation equivalent rate, but since November they eased to about 3%.
Consequently, trend wage growth based on these inflation expectations (W*) started to ease again, suggesting that there is some additional wage disinflation in the pipeline.
But W* is consistent with about 3% PCE inflation, above the Fed’s 2% inflation target. So, any actual further wage growth easing in line with this measure will keep wage growth at an above-target pace.
Most wage growth measures were stable in November and corrected for expected inflation, trend productivity growth and trend labor share growth, these continue to boost households’ real incomes and spending.
Inflation Expectations
As familiar to some readers, one of the W* trend wage growth measures I use builds on inflation expectation surveys drawn from “Main Street”, i.e., five inflation expectations samples from households and firms. Following 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).
On November 30th, the then available individual expectations series are plotted in the chart above alongside the corresponding estimated common factor across these series, as well as scaling the factor in year-on-year PCE inflation terms. At that point the common trend across these surveys suggested “Main Street” inflation expectations that had been stuck around 3.2% between July and October, with tentative signs of some acceleration in November.
Since the aforementioned November 30th note, three out of the underlying surveys got updated, one with observations for November and two surveys providing expectations for December:
The December 8th preliminary University of Michigan survey for December, which showed year-ahead inflation expectations plunging from 4.5% in November to a provisional 3.1% in December.
The December 11th November Survey of Consumer Expectations from the NY Fed that indicated a decline in year-ahead expectation from 3.57% in October to 3.35%.
The December 13th Atlanta Fed Business Inflation Expectations survey for December pointing to a decline in median 12-month ahead inflation expectations to 2.35% from 2.50%.
The re-estimation of the common factor across “Main Street” inflation expectations using the updated individual expectations now suggests a downward revision to November inflation expectations from 3.45% in PCE terms to 2.99% (chart above), a decline from a slightly downwardly revised 3.15% level in October. The preliminary estimate for December suggesting another slight decline to 2.95%, so after stalling at a PCE year/year equivalent of 3.2% for July-October “Main Street” inflation expectations eased to about 3% since November, with tentative signs of some downward momentum again.
Trend Labor Productivity and Labor Share Growth Rates
Earlier in the month, revisions for the BLS's "Productivity and Costs" report for Q3 were released, with a bit more of an acceleration of labor productivity growth than initially estimated. Labor productivity remains below-trend so catch-up dynamics will likely keep growth rates temporarily elevated. Nonetheless, the year/year trend labor productivity growth rate for Q3 remains subdued historically at around 1.4% year/year, as is shown in the chart below.
The labor share equals the ratio of total workers compensation relative to nominal output of businesses. As for labor productivity, I approximate the labor share trend by taking the average of six trend estimation methods applied to the actual labor share data, as outlined in my original W* note.
The chart above shows the revised labor share trend estimate. The revised labor share trend estimated continues to show a drift down. This means that the Fed needs to see even lower wage growth levels than what is usually assumed in the policy debate to have these rates in line with its inflation target.
Wage Growth
To recap, to assess wage growth trends I combine the following three ingredients I discussed in the previous sections, i.e.,
The trend productivity growth estimate described earlier (assuming a Q4 trend labor productivity level based on the trend labor productivity change over the past quarter, followed by linear interpolation from the quarterly to the monthly frequency).
A similar estimate of trend labor share growth (assuming a Q4 trend labor share level based on the trend labor share change over the past 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 firm and household surveys or the 2% inflation target.
The sum of 1-3 above 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 over the month. In addition, I use in the chart a composition-adjusted average hourly earnings (AHE) wage series for production and non-supervisory workers as constructed at the Atlanta Fed, which can be found here.
As in previous months, the chart above continues to suggest that wage growth overshoot the expectations-based W* metric, suggesting positive expected real wage growth throughout the first three quarters of 2023 and into Q4. And compared to the previous update, the year-ahead expectations W* metric resumed declining again, in line with the earlier discussed easing in “Main Street” inflation expectations. Note, though, that,
Actual wage growth (two of out three measures remained stable over the month) and the expectations-based W* measure (currently in line with about 3% PCE inflation) still outpace the trend wage growth rate that is consistent with the Fed’s 2% inflation target.
With the declining trend in the labor share incorporated into the W* measure, the Fed needs to see year/year wage growth of about 2.6% for it to be consistent with 2% PCE inflation over the medium term.
Implications
The data on “Main Street” inflation expectations do suggest that, for now, expectations again eased somewhat over the past two months after remaining stuck for four months. Consequently, the expected degree of easing of wage growth picked up again but remain substantially above inflation target-implied rates.
The positive expected real wage growth rate seen throughout 2023 owing to a strong labor market, has been a boost for expected real wage incomes of household. This has kept consumption at robust levels. In turn this has kept inflation expectations at above target levels, despite the recent easing, and, thus, the rate of trend wage growth.
This interplay between labor market strength and solid consumption spending remains a major risk for a Fed that made a dovish pivot going into 2024. As long as “Main Street” near-term inflation expectations remain out-of-whack with 2% inflation, wage and spending growth rates remain so as well. The longer this takes the more above-target inflation expectations get entrenched in firms’ and households’ behaviors.