Wages and Inflation Expectations - January 2024 Update
Wage growth rates still overshoot the pace consistent with the inflation target. But inflation expectations eased notably below 3% in PCE inflation terms.
It is that time of the month when I update my framework, which 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 December, labor productivity and labor share data for Q3 and updates of inflation expectations data for December and January, this note will update the above-mentioned wage growth framework.
Key takeaways:
Between July and October “Main Street” inflation expectations had been stuck around a 3.2% PCE inflation equivalent rate, but since November they eased notably below 3% with a preliminary reading for January of a 2.6% PCE equivalent rate.
Consequently, trend wage growth based on these inflation expectations (W*) continued to ease, suggesting that there is potentially additional wage disinflation in the pipeline.
With W* consistent with about 2.6% PCE inflation, this wage growth trend measure is closing in on the Fed’s 2% inflation target. But any actual wage growth easing in line with this measure will still keep wage growth at an above-target pace.
Wage growth measures were relatively stable in December and corrected for expected inflation, trend productivity growth and trend labor share growth, these continue to boost households’ real incomes and spending.
Inflation Expectations
A hopefully by now familiar product I publish regularly is a W* trend wage growth measure that builds on inflation expectation surveys drawn from “Main Street”, i.e., five inflation expectations samples from households and firms. Following my original W* note, I extract a common signal from these inflation survey measures by means of a single dynamic common factor that depends on its own lag using the approach of Banbura and Modugno (JAE, 2014).
I have plotted in the chart above the available individual expectations series I used for my post-PCE report note of December 22nd alongside the corresponding estimated common factor across these series, as well as the scaling of this 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 but drifted down to 3% by November and December.
Since the aforementioned December 22nd note, three out of the underlying surveys got updated, one with observations for December and two surveys providing expectations for January:
The January 19th preliminary University of Michigan survey for January, which showed year-ahead inflation expectations declining from 3.1% in December to a provisional 2.9% in January (which would the lowest level of this measure since 2020).
The January 17th Atlanta Fed Business Inflation Expectations survey for January pointing to a decline in mean 12-month ahead inflation expectations from 2.35% to 2.23%.
The December 11th NY Fed December Survey of Consumer Expectations that indicated a decline in year-ahead expectation from 3.36% in November to 3.01%.
The re-estimation of the common factor across “Main Street” inflation expectations using these updated individual expectations is depicted in the chart above and now suggests a slight downward revision to November inflation expectations from previously 3.02% in PCE terms to currently 2.97%, as well as a notable downward revision for December from 3.03% to 2.63%. The preliminary estimate for January stands at 2.64%, so after stalling at a PCE year/year equivalent of 3.2% for July-October “Main Street” inflation expectations have showed since then a pronounced downward momentum towards a new stable level of 2.6%.
Trend Labor Productivity and Labor Share Growth Rates
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 labor share trend estimate, which 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.
The chart above shows that both Atlanta Fed wage growth measures have been stable at around 5.2% year/year since the summer of 2023. The composition adjusted AHE measure has been accelerating since the summer, which I discussed after the publication of the December jobs report, causing the smoothed year/year growth rate to stabilize around 4.3% in November and December (purple compound line in the chart above). These wage growth measures have been overshooting the expectations-based W* metric consistently since Q1 2023, suggesting positive expected real wage growth since then and into 2024.
Compared to the previous update, the year-ahead expectations W* metric declined further (blue line in above chart), in line with the earlier discussed easing in “Main Street” inflation expectations. Do note, though, that,
Actual wage growth and the expectations-based W* measure (currently in line with about 2.6% 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 expectations eased notably over the past three months after remaining stuck for the prior four months. Consequently, the expected degree of easing of wage growth based on inflation expectations picked up again but still remain above inflation target-implied rates albeit less so than before.
Wage contracts typically are staggered across sectors and across the year, so any convergence in wage growth towards rates consistent with the currently implied 2.6% year ahead PCE inflation rate could be gradual. But if this inflation expectations estimate is indeed representative of expectations of wage negotiators, wage contract renegotiations throughout 2024 should result in a convergence of actual wage growth metrics towards the blue line in the chart above throughout the year. Given the current strength of the economy, the Fed likely will be patient in waiting for signs of such a gradual convergence of wage growth towards inflation expectations-consistent rates.
The positive expected real wage growth rate seen since Q1 2023 owing to a strong labor market, has been a boost for expected real wage incomes of household. This has resulting in robust levels of consumption spending. This interplay between labor market strength and strong 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.
As I laid out earlier after the December FOMC meeting, all of the above is another set of reasons why the Fed will be patient in bringing down the Fed funds rate this year with the first cut not likely to happen before mid-2024.