In a recent GMD focus piece, we outlined why we expect US core inflation to rise this year – we forecast core CPI to reach 2.1% in Q4 14, up from 1.6% at present. We look for the core PCE price index to rise to 1.7% in Q4 14, up from the current reading of 1.1%.
One factor in our outlook for a modest firming in core inflation is rising wage growth. In her press conference following the March FOMC meeting, Fed Chair Janet Yellen said that wage growth had been very low and that annual wage growth of 3-4% would signal that labor markets were operating more normally.
Although current wage growth is well below this range, several indicators suggest that it is ahead of where it has been in past cycles.
The average hourly earnings of production and nonsupervisory employees rose 2.2% y/y through March, up from the trough of 1.3% in October 2012. We focus more on this series as opposed to the series for all employees because it has a much longer time series for comparison to previous cycles and we think that the hourly wage is a more informative measure because it covers workers who are paid by the hour, as opposed to salaried workers who make up a larger portion of the all-employee series.
Notably, average hourly earnings growth did not reach the current pace of 2.2% in the last cycle until the unemployment rate had fallen to 5.4%; consistent with our view that NAIRU has risen.
Data from the National Federation of Independent Business (NFIB) Survey for March, released earlier this week, tell a similar picture. The percentage of firms raising compensation in the previous 3-6 months rose to 23% in March from 19% in February, the strongest reading since early 2008.
Readings between 25 and 30 have been associated with the last three expansions. This series has tended to be a good leading indicator of average hourly earnings over the coming 12 months and, like our projection for a further decline in the unemployment rate, suggests stronger wage growth ahead. Small business also expects this; a net 14% of firms in the March survey said they planned to raise compensation.
Finally, the NFIB survey indicates growing labor scarcity and, potentially, a skills mismatch. Although small business sees government regulation and taxation as the most important problems, an increasing number of firms indicate that the quality of labor is becoming an issue.
In the March survey, 9% of small business identified poor labor quality as the main problem they face, about double the rate during the early stages of the recovery. This series has mirrored trends in the percentage of firms with positions that they are unable to fill, which held at 22% for the third straight month through March. This level is only modestly below the 24.4% average between 2006 and 2007.
Altogether, we see the data as indicating that the unemployment rate is sending as accurate a signal about the degree of slack in labor markets as it has in recent cycles. In other words, we see the data as signalling that the current unemployment rate is less elevated relative to longer-run unemployment than the Fed thinks.
Given that we expect the unemployment rate to fall to 6.1% in Q4 14 and 5.5% in Q4 15, and that we see NAIRU as having risen, we look for a continued modest firming in wage growth. If accurate, this would point to wage growth of 3% or better in 2015, the lower end of Chair Yellen’s estimate of a healthy labor market.
That said, it remains to be seen when and to what degree higher wages translate into higher actual rates of inflation. We assume firms will be able to pass along some of the higher wage bill to the end-consumer, but this pass-through is likely to be gradual and with variable lags.
Our expectation is that the downward pressure on global goods prices will moderate and, together with faster wage growth, less disinflation from medical care services, and rising shelter inflation, produce a gradual rise in core inflation later this year.