North America August 10, 2018 / 07:31 pm UTC

U.S. Wages Will Rise, but Slowly

By Kevin Harris
  • Wages matter. The Fed tracks wage gains in assessing the policy environment. Wages have, most of the time, been positively correlated with inflation. As a major input cost, wages have a strong influence on business profits. Household spending relies mostly on wages. We expect wage gains to accelerate, but only modestly over the next few quarters, despite a tight labor market. Here, we explain why.
  • Bottom line: Much of the discussion of wages relies on the historical relationship between labor market slack and labor compensation, but that relationship has changed substantially. Forecasts based on that relationship will predict wage gains too large and too quick to match current reality. Today’s business managers have earned their living by keeping costs down, and that experience will keep them from using wage increases to compete for labor.
  • Market implications: Wage gains are unlikely to accelerate much, and so are unlikely to lead to wage-push inflation. That limits the odds of the Fed having to accelerate monetary tightening in order to snuff out inflation. As a consequence, the odds of a Fed-induced recession are also limited. While yields will rise, volatility in the fixed income market will remain modest relative to past cycles because of the reduced risk of either an inflation surprise or policy mistakes.

Figure 1: Real Labor Compensation vs Labor Productivity (% change since 1947)

Source: Bureau of Labor Statistics, Continuum Economics

When the Past Is a Poor Guide to the Future

One important driver of our view is that historical relationships between wage gains and other labor market indicators show signs of significant structural change; historical relationships in the data are likely to be misleading. That makes estimates of future wage growth based on historical evidence subject to substantial errors. To a very large extent, wage forecasts based on assessments of labor market tightness will tend to be too high.

One well-known example of a structural change can be seen by comparing gains in real workers compensation to gains in labor productivity (Figure 1). Simple economic theory holds that workers will be paid the value of the marginal product of their labor. Up to 1973, that seemed true—but it no longer does. In fact, around the year 2000, the divergence increased, suggesting a further structural shift away from paying workers the value of their marginal product. Some very competent economists claim that productivity gains remain the key to improved labor compensation. Rising productivity may be a necessary condition for pay gains, but it is clearly not a sufficient one.

If one theory falls short, perhaps another will succeed; increasing demand for labor should boost wages. Data on unfilled job openings should illuminate the state of labor demand. Prior to and during the Great Recession, a narrowing of the gap between job openings and hires was associated with an acceleration in hourly earnings gains, and a widening in the gap was associated with slower earnings gains (Figure 2). More recently, that relationship has weakened considerably. In late 2015, for instance, job openings surpassed hires (to considerable applause), but average hourly earnings gains were actually slowing at the time. 

Figure 2: Openings and Hires vs Wage Gains—A Broken Relationship

Source: Bureau of Labor Statistics, Continuum Economics

This breakdown in the historic relationship between economic conditions and labor compensation makes it difficult to forecast wage growth. Keep in mind that these structural changes mostly result in slower wage gains than suggested by other labor market indicators. 

Do We Have the Wrong Skills? 

Often, a skills mismatch is blamed for the large number of unfilled jobs. If a lack of skill is the problem, one would expect to see pay rising slowly for jobs requiring limited skills. That does not fit the pattern in the data. Workers in accommodation and food service and in retail have received among the biggest percentage gains in hourly earnings (from a low base), just behind information tech and finance and insurance (Figure 3). The wage gain in the information and financial sectors probably reflects competition for skills, but competition for skills is an odd explanation wage gains for room cleaners, food servers and retail cashiers. (Overall, empirical evidence for such a skills mismatch is not strong.)

Figure 3: Gains in Average Hourly Earnings by Sector Since January 2010

Source: Bureau of Labor Statistics, Continuum Economics

If a skills deficit accounted for the large number of unfilled jobs, then we should see a more rapid rise in unfilled openings in highly skilled sectors than in sectors with a lower skill requirement. Neither of these is borne out in the data (Figure 4). For instance, job openings for accommodation and food services and for retail, sectors which do not generally require a high level of skill, have increased by between 200% and 250% since 2010. At the same time, openings in information technology, where skill requirements are high, have risen far less (Figure 4). 

Figure 4: Gains in Job Openings Since January 2010

Source: Bureau of Labor Statistics, Continuum Economics

If wage gains could be predicted by demand for labor, then wage gains should be associated with unfilled job openings. In that case, Figure 4, showing the rise in job openings since 2010, should look a good bit like Figure 3, showing wage gains. In fact, they do not look much alike. 

When Data and Theory Fall Short, Consider Culture

This brings us to the heart of our view that compensation gains will remain modest. We see evidence that today’s business culture is ill-disposed to compete for labor by increasing compensation. Many in the current managerial class lived and managed through the worst business downturn and the worst labor market in well over half a century. They have seen the rise of a global labor market. They have used part-time and temporary workers to a larger extent than their predecessors. They have been part of the downward drift in labor’s share of the economy. Their experience has focused more on keeping costs down than on attracting and holding domestic workers. 

Cultural factors are not apparent in standard economic data, but are obvious in business surveys. For instance, the private sector’s average planned pay increase for 2018 was 3.0%, little changed from 2.9% in 2017, and budgets for bonus pay are down slightly, according to Aon’s annual compensation survey. (Those are nominal figures. With inflation picking up, real compensation gains may be weaker this year than in 2017.) More firms plan to cut or eliminate pay increases for lesser performers than boost incentive pay for good performers. Many firms may also be holding on to hiring standards appropriate for a slack labor market despite current tight conditions, demanding a broader set of qualifications than are actually needed to do a job. 

Figure 5: Rate at Which Workers Quit Their Jobs on the Rise (quits as share of labor force)

Source: Bureau of Labor Statistics, Continuum Economics

One consequence of firms’ reluctance to increase wages is that workers are quitting their jobs at a high rate (Figure 5). The quit rate has matched the high of the past expansion in each of the past four months, and the trend is clearly toward an even higher rate of job-leaving. When firms are unwilling to raise wages enough to hold on to their workers, workers switch jobs. This movement to new jobs for better pay is also evident in the gap between pay increases for those who stay at their jobs and those who switch (Figure 6). That gap is quite wide in recent months, and has been wider on average in this expansion (0.5%) than in the prior cycle (0.3%).

Figure 6: Gains in Average Hourly Earnings: Job Switchers vs Job Stayers (y/y % change)

Source: Atlanta Fed Wage Tracker, NBER, Continuum Economics

Managers can change their thinking and practices, but that sort of change takes time. For now, businesses show a greater reluctance to increase pay than to lose workers. That reluctance has meant slow compensation gains so far in this cycle, and until business managers change their thinking about pay and performance, we expect compensation gains to remain muted and turnover to remain high.

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Analyst Certification
I, Kevin Harris, the lead analyst certify that the views expressed herein are mine and are clear, fair and not misleading at the time of publication. They have not been influenced by any relationship, either a personal relationship of mine or a relationship of the firm, to any entity described or referred to herein nor to any client of Continuum Economics nor has any inducement been received in relation to those views. I further certify that in the preparation and publication of this report I have at all times followed all relevant Continuum Economics compliance protocols including those reasonably seeking to prevent the receipt or misuse of material non-public information.