Are Wage Gains Ready to Skyrocket?

Most people take for granted that wages have shown lackluster growth over the last 20 years or so. So I put my data cap on and starting looking at numbers. My first takeaway is that there are way too many numbers. We might want to know how wages have kept up with productivity. That seems reasonable. But then one needs to find companion series for wages and productivity, so we can compare apples with apples. That can be done but do we want to compare these series for all workers? For all manufacturing workers? For medium-income workers? Over how many decades?

Another comparison of wages could focus instead on how wages changed compared to prices – that is, did wages keep up with inflation? Again, there are many indicators from which to choose – various measures of wages and even more measures of inflation. To makes matters even more challenging – some of the series go back to 1929 while others just got started in 2006.

What I am saying here if it isn’t obvious is that it is time for a nice cold JD. It is also time to make some decisions. No matter which choice I make some of you will want to scold me. But I made a decision anyway. I decided to focus on the years from 1968 to 2017. Going back to 1968 means we have a rich enough data set so that we can put today’s low inflation numbers in perspective with past times when US inflation was higher. I also decided to use the CPI as my inflation variable. Earnings of Production and Nonsupervisory Workers in the Business Sector is my measure of wages.

What I examined is how earnings kept up with inflation during the past half-century. To do this I calculated three times series –  % change in earnings (Edot), % change in prices (Pdot), and % change in the buying power of the earnings (calculated as the first series minus the second one (Edot minus Pdot)). For example, in 1970 the % change of earnings was 6.1%. Prices rose by 5.6%. Therefore the buying power of the earnings rose by 0.5% (6.1-5.6) in 1970. 1970 is an example of a year when earnings did quite well. The wage increase of these production and nonsupervisory workers was larger than the increase in the cost of living.

As I look down my table (below) I notice there are lots of years when the buying power of earnings was positive while there were also years when workers did not keep up with inflation (buying power of earnings was negative). When the buying power of earnings was negative – it meant that workers were getting behind – and that they might at some point want to catch up. 

The earnings buying power went down considerably from 1973 to 1975 and then again from 1978 to 1981. In those years inflation was hitting double digits and despite some good years of earnings growth – these earnings just couldn’t keep up with inflation. In 1980 earnings rose by almost 9% but since inflation was 12.5% workers fell behind. And strangely enough, it was not until 1995, after the inflation rate had fallen considerably that earnings began rising faster than inflation. The years 1995 to 2002 were catch-up years. During those years earnings rose a total of about 10 points more than inflation.   

Between 2003 and 2012 there was no real pattern. But then between 2013 and 2017 there was a very clear pattern – and brace yourself for this – wherein inflation  generally stayed below 2% per year – wages of production and non-supervisory workers were rising by about 2.4% per year. Thus, earnings were catching up as the buying power of earnings increased. 

There are lots of ways to go from this point. But let’s not forget one thing. While workers always want higher wages – the thrust for higher wages is often driven by how far wages stretch to buy goods and services. This data suggests that while there have been times when the buying power of the wages declined (in the 1970s and then from the mid-80s to the mid-90s) – the last 15 years cannot be classified as a time when inflation robbed workers of their buying power. Especially the last 15 years show just the opposite. Workers might not love the size of their wage increases – but these increases have been well above the inflation rate. And therefore, there is no clear pent-up explosion of wage increases looming around the corner.

As I said above, there are lots of ways to go from here. I am not saying that all workers are just fine. I am not saying there are no labor market issues to deal with. What I am saying is that the rate of growth of earnings compared to the cost of living is important for understanding future wage and price growth. The earnings of production and nonsupervisory workers in the USA might not be growing rapidly but they have, of late, been growing faster than the cost of living. That needs to be factored into our forecasts for the future. 

Table

	Earnings			CPI						Edot -
Year	Dec			Dec		Edot		Pdot		Pdot
1968		3.11	35.5
1969		3.30	37.7		6.1		6.2		-0.1
1970		3.50	39.8		6.1		5.6		0.5
1971		3.73	41.1		6.6		3.3		3.3
1972		4.01	42.5		7.5		3.4		4.1
1973		4.25	46.2		6.0		8.7		-2.7
1974		4.61	51.9		8.5		12.3		-3.9
1975		4.87	55.5		5.6		6.9		-1.3
1976		5.23	58.2		7.4		4.9		2.5
1977		5.61	62.1		7.3		6.7		0.6
1978		6.10	67.7		8.7		9.0		-0.3
1979		6.57	76.7		7.7		13.3		-5.6
1980		7.13	86.3		8.5		12.5		-4.0
1981		7.64	94.0		7.2		8.9		-1.8
1982		8.02	97.6		5.0		3.8		1.1
1983		8.33	101.3		3.9		3.8		0.1
1984		8.61	105.3		3.4		3.9		-0.6
1985		8.87	109.3		3.0		3.8		-0.8
1986		9.01	110.5		1.6		1.1		0.5
1987		9.28	115.4		3.0		4.4		-1.4
1988		9.60	120.5		3.4		4.4		-1.0
1989		9.98	126.1		4.0		4.6		-0.7
1990		10.35	133.8		3.7		6.1		-2.4
1991		10.64	137.9		2.8		3.1		-0.3
1992		10.90	141.9		2.4		2.9		-0.5
1993		11.18	145.8		2.6		2.7		-0.2
1994		11.47	149.7		2.6		2.7		-0.1
1995		11.81	153.5		3.0		2.5		0.4
1996		12.25	158.6		3.7		3.3		0.4
1997		12.76	161.3		4.2		1.7		2.5
1998		13.22	163.9		3.6		1.6		2.0
1999		13.70	168.3		3.6		2.7		0.9
2000		14.29	174.0		4.3		3.4		0.9
2001		14.75	176.7		3.2		1.6		1.7
2002		15.21	180.9		3.1		2.4		0.7
2003		15.47	184.3		1.7		1.9		-0.2
2004		15.86	190.3		2.5		3.3		-0.7
2005		16.36	196.8		3.2		3.4		-0.3
2006		17.05	201.8		4.2		2.5		1.7
2007		17.69	210.0		3.8		4.1		-0.3
2008		18.38	210.2		3.9		0.1		3.8
2009		18.84	215.9		2.5		2.7		-0.2
2010		19.22	219.2		2.0		1.5		0.5
2011		19.56	225.7		1.8		3.0		-1.2
2012		19.89	229.6		1.7		1.7		-0.1
2013		20.34	233.0		2.3		1.5		0.8
2014		20.73	234.8		1.9		0.8		1.2
2015		21.25	236.5		2.5		0.7		1.8
2016		21.78	241.4		2.5		2.1		0.4
2017		22.31	246.5		2.4		2.1		0.3

Inflation Part 2. The Real GDP Gap

Last week I tried to explain why I am not a big fan of the Phillips Curve. If you were not bored by that little detour then maybe you won’t fall asleep this time either. We in the USA are clearly thinking about inflation these days. Is it going to come back and scare the bejeezers out of us? Or not. Since my crystal ball is at the Hyundai place for its 30,000-mile service, I won’t regale with you with any forecasts. But I will pull out some data that I think is pretty interesting with regard to inflation. To give away the ending -- it is not easy to see a 70s style inflation roast.

Last week I punched at the Phillips Curve and concluded it was a fake for the real thing – a supply and demand analysis of inflation. Since supply and demand puts most people to sleep, I decided that I would use a close cousin called the real GDP gap. The real GDP gap measures the difference between actual output and something we call potential real GDP. Remember when you were a little kid and they said you had the potential to be the next Liberace? You were not yet the equal of Liberace and probably were not even equal to Elton John. But they thought that you had a lot of potential. Potential real GDP is similar in that it is not what we actually produced but is a measure of what we are capable of producing (if all of us were working).

When we subtract actual GDP from Potential GDP we get a gap that is a measure of how far off from potential we are. If that gap is very large, then we would be saying that demand is not strong enough to lead to output equal to our potential. That is the kind of time when prices and wages are not growing very fast. But if real GDP is a lot higher than real potential GDP, then we have a gap that represents a lot of demand compared to what we can usually produce. During those times we produce more than potential output because more of us are out of the house and into jobs! These time periods are not sustainable because most of us don’t like to work that much all the time and because it often causes inflation.

Today I look at those historical time periods in which output was a lot higher than potential real GDP. It turns out that since 1960 we have had six of those episodes. The table at the bottom contains information for those six and for the seventh one that just recently started near the end of 2017. Since the latter has lasted only three quarters, it ain’t much to look at. But those three quarters make us wonder if this will be like any of the past six time periods when real GDP exceeded potential.

The six episodes were as short as three quarters (1989) and as long as 24 (1964). The average time was about 11 quarters or just short of three years. Based on these almost 60 years of experience in the USA, output has a tendency to be higher than potential for just about three years at a time.

How much output was above potential varies too. During the 1964 episode, output started out a tiny bit above potential (0.7%) and was as high as 5.6% greater than potential during one of those quarters. It averaged about 2.6% above potential over those 24 quarters. This shows it is possible for real GDP to grow very rapidly relative to its potential. Only in the 1972 episode did output again show such strength when it averaged 2.3% above potential. Since 1978, we have very few cases of real GDP being 1% above real GDP.

What about the inflation rate? In five of the six episodes, the inflation increased. In the 24 quarters from 1964 to 1969, the inflation rate rose by 3.2 points, from 1.5% to 4.7%. In the next time frame, it increased by 6.7 points as it went from 3.3% to 10% in the early 1970s. Of course you could say the inflation rate tripled in both of those time periods.

Notice that the inflation rate responded heartily to gaps through 1980 but much less thereafter. This mostly reflects that gaps became smaller but might also question the response of inflation to any given gap.

            Change in the Inflation Rate

            From Beginning to End of Period

            1964-1969     3.2

            1972-1974     6.7

            1978-1980     4.2

            1989-1989   -0.4

            1997-2000     1.3

            2006-2007     0.3

            2017-2018     0.3

Nothing is proved here. But clearly it will take a while before we can say anything about how much inflation will rise in the coming years. If the growth rate of real GDP does not pick up substantially in the next years it is hard to see how a gap analysis would yield a large change in the inflation rate. If the inflation rate is close to 2% right now, then should we be worried about it rising much beyond 3%? If so, would that be a disaster? If not the gap, then what else might cause inflation to rise in the coming years? 

Table: Gap and Inflation

                           GAP*                Inflation Rate**

1964:1    0.7  5.6  0.5  2.6      1.5   4.7   4.7  3.2

1969:4          

1972:2    1.6  4.3  0.6  2.3      3.3 10.0  10.0  6.7

1974:2

1978:2    1.8  2.3  0.1  1.3      6.8  11.0 11.0 4.2

1980:1

1989:1    0.2  0.2  0.2  0.2      4.5   4.1  4.1 -0.4

1989:3

1997:2    0.3  2.0 0.7  0.9      1.8  2.5   2.5  0.7     
2000:3

2006:     0.5  0.4  0.4 0.2       3.0  3.3  3.3   0.3

2007:4

2017:    0.2  0.7  0.7  0.5      1.5  1.7  1.8   0.3

2018:1

 *Gap is the percentage that the actual GDP is above potential GDP. The four numbers represent that % gap during the first quarter, the highest quarter, the end quarter, and the average of all the quarters in that time period

** Inflation is measured by the annual change in the Personal Consumption Expenditures Deflator in that quarter relative to the same quarter in the year before. The four numbers reflect the measurement in the first quarter, the highest quarter, the end quarter, and the change from the beginning to the end quarter.

Lesson 22 The Phillips Curve

Below is something called the Phillips Curve. I thought it had expired but I read an article in the Wall Street Journal last week and realized it is back to haunt us. So I am on a mission today.

Like the Laffer Curve, the Phillips Curve is one of those graphical devices named after an economist that is misunderstood and totally abused. Like a good training bra, these curves have their time and place but can easily be misapplied.

I'll save Art Laffer and his curve for another time. A.W. H. Phillips studied wage change and unemployment in the UK from 1861 to 1957. I am not sure why his parents gave him so many initials and that deserves a lot of study, but I won't go into that today either. To make a very long story short, we Americans who wanted to be great again in the 1950s decided to steal Mr. Phillips' curve and apply it to our study of inflation and unemployment in the US.

The result of this study is to think that there might be a stable relationship between inflation and unemployment. Thus we draw the curve with a negative slope and pretend that it sits there until hell freezes over.  For you friends who are not mathematicians, this means that any reductions in the unemployment rate should cause the inflation rate to increase. Or, in other words, when the economy grows rapidly enough to reduce the unemployment rate this puts pressure on markets. Tight labor markets mean that wages rise faster. Tight goods markets mean that prices rise faster. That doesn't sound so crazy, does it?

In our current context in the US, we recently saw the unemployment rate decline to 3.9%. Applying the Phillips Curve means that inflation should be rising. Applying the Phillips Curve to the future means that if the unemployment rate remains low or heads lower -- then surely inflation will rise even more. Again, that doesn't sound so crazy. Of course, we wonder why inflation has not already soared given the tremendous declines in the unemployment rate.

The confusion is that economists are used to models that focus on supply and demand. And while discussions of the Phillips Curve often involve throwing around those words, the Phillips Curve is neither a supply curve nor a demand curve and this drives us crazy. What is it? Basically, it is a useful construct that amalgamates supply and demand but in ways that satisfy only the user. One user says one thing; another user says another.

This lack of consensus arises because we are using this construct as a proxy for an inflation forecasting equation. An inflation forecasting equation stems from a model. This explicit model has two components -- the aggregate demand for goods and services (AD) and the aggregate supply of goods and services (AS). To understand changes in the inflation rate, you must examine all the major things that impact a country's AD and AS. One of those things is the unemployment rate.

Did I underline the word one? I should have. Only one of the zillions of important things that impact inflation is the unemployment rate. Don't get me started because a zillion is a lot of things to discuss. But consider some of the important ones. Oil prices are starting to rise again these days. Might that impact inflation in the USA? What about when prices of mobile phone services fell? Would that impact the national price level? Declining productivity? Global competition? Agricultural surpluses?

Some economists understand that when any of these other inflation-causing factors change, then the whole Phillips Curve shifts. Things that cause inflation to rise cause an upward (leftward) shift. Things that cause inflation to fall cause a downward (rightward) shift. The Phillips Curve is not an immutable object nailed to the floor. It bounces around like Nolan in a bounce house. Thus, pretending that the Phillips Curve just sits around all the time is bound to lead to errors in one's inflation forecast.

Notice what we are saying these days. As the unemployment rate falls we are pulling our hair out about rising inflation. We are sure that the Fed will, then, more aggressively fight inflation. And because the Fed will react like Pavlov's pup, many are already forecasting a recession. While all that might be true, it ignores a lot of other things going on that might preclude the inflation rate from rising. Maybe the global economy is slowing down? Maybe we have plenty of workers ready to jump into the labor market or at least switch their status from part-time or from underemployment. Maybe tax reform will improve productivity and facilitate more competitive pricing. Maybe continued innovations and competition in IT products will reduce prices we pay for all sorts of products. Maybe Alexa will wash your car for free.

The Phillips Curve is a pedagogical device. It doesn't sit still for anyone. Focusing on the impact of unemployment on inflation is like trying to forecast how your kid will behave after eating a cookie. While the cookie might  have one impact, myriad environmental and emotional factors should not be ignored. Give the kid the cookie!

The Tail is Wagging the Dog

Two weeks ago I proclaimed that macro was sleeping and wouldn’t you know it, all the news lately has been about macro policy. Much of the discussion among economists and journalists shows that macro must have one eye open. These policy discussions are as confused as I have ever seen them.

Here are some of the themes. First, the Fed is pretty sure that inflation is going to rise above the cherished 2% target, and they will have to attend to a potential inflation monster with a more aggressive monetary tightening. But then they admit that inflation is not roaring back yet and there is always the worry that a rough policy would lead us into a recession. Second, recent economic growth news from the UK and Germany have us worried that global growth may be in a new tailspin. Just days ago, we were worried that the world might grow too fast. Wham bam – now we are not so sure. Third, we might be headed into a global trade war pitting the US against China, Europe, and several far-off planets. Or maybe not.

Isn’t macro policy fun? It is true that all of us except for John Travolta cannot see the future, and economists always disagree about best policies for any given 7-minute time frame. But today we find ourselves more confused than ever. Why does macro seem so lame these days? What happened to our rocket science?

My explanation begins with the vivid notion that the tail is now wagging the dog. Nolan knows that a dog is supposed to wag its tail and not vice versa. The dog is short-term macroeconomic oscillation. The tail is everything else. It used to be that everything was about the dog. Central banks and treasuries are laser focused on short-term macro stuff. Is the consumer going to be happy this year and buy another car? 

Will tax cuts cause consumers and businesses to spend more? Are firms going to build inventories? Will rising oil prices rob consumers of money they could spend on JD and potato pancakes? In that world, the dog is our focus and we use monetary and fiscal policies to buff up spending when conditions are weak and the opposite when people are spending too much.

But the dog is a mere pussycat today. And the tail is roaring. The tail is the aftermath of the worst world recession that the Tuna can remember. The world economy never entirely exited that recession. We lumber along. Some wonder if capitalism is doomed. Others worry about the lack of enthusiasm firms have for buying new and exciting equipment. Then there is that debt overhang from beer-guzzling college students to pot-smoking boomers with hip pain.

This dragging tail of an economy is also weighed down by a disenchantment of both the young and old for the labor force and the nonchalant attitudes about investment and the resulting lagging productivity gains.

The sad fact is that our dog-oriented policy makers are in the dark when it comes to the tail. They know how to fix the dog and that’s where they focus their attention. If you are a hammer, then every problem is a nail! But dudes, it ain’t the dog. Focusing on the dog means you miss the point. Focusing on the dog means that you are confused by the macroeconomic data. John Maynard Keynes said that we are all dead in the long-run so we should focus on the short-run. But today the tables have turned. We seem to be very alive in the long-run, and the short-run will be a very dull and confusing place if we don’t take care of the future.

Like a 24-hour news cycle, the Fed is always in our thoughts. But the Fed has little to do with the long-run except to provide ample money for long-term growth. All this noise about whether they are going to raise rates 3 or 9 times this year sells soap but is mainly a distraction. Whack-A-Mole economic performance in the US and abroad is similarly uninteresting. The world economy is stuck in neutral, and it has everything to do with longer-term challenges.

We need to put Keynesian economics to bed. It’s hurting our sleep. Let’s require all decision makers at the Fed and in Congress to take a course in long-run macro. But that’s silly. I doubt most of them are smart enough to understand it. And none of our 24 hour news station would find it interesting enough.