Fed should embrace wage gains, not fear inflation

Fed should embrace wage gains, not fear inflation
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The economy grew close to 3 percent last year and is on track to grow 3 percent again this year. Given the close inverse relationship between changes in real GDP growth and the unemployment rate, another reasonably strong year of economic activity should push the unemployment rate down to 3.5 percent.

If so, this would produce its lowest reading since Q2 1969. If this forecast pans out, wage growth is likely to accelerate. But it will not accelerate for the reasons that investors might expect: a bidding up of scarce labor resources that leads to an inflationary impulse.

For GDP to grow 3 percent, productivity needs to continue to accelerate. It is currently growing 1.5 percent, which is about double its trailing 5-year trend. Productivity would need to increase another 50 basis points to 2 percent, which is reasonable in our view.


It is not unusual for productivity to improve late in an economic cycle, because a shortage of labor causes companies to find more efficient ways to operate. The recently passed tax bill also incentivizes companies to invest in labor-saving capital spending.

Over time, this should lead to faster productivity growth because workers will have the necessary capital to do their jobs more easily. The ability to produce more with the same amount of labor input is the definition of productivity growth.

Consequently, if we combine 2-percent productivity with 1-percent growth in the labor force — its current trend — the simple arithmetic produces 3-percent GDP growth. A sub-4-percent unemployment rate combined with back-to-back years of 3-percent real GDP, which is something that has not happened since 2004-05, will probably engender some inflation concern. It should not.

A productivity-led increase in wages this year would not be inflationary. The same thing happened in the late 1990s, which was the last time the economy experienced real wage growth. Back then, wage gains were up in excess of 4 percent, but productivity was booming as well, up over 3 percent.

This resulted in very modest gains in unit labor costs. It was no wonder then that inflation was so low at the time. Core inflation grew at just a 1.4-percent annualized rate for the three years ending 1999.

However, we are concerned today’s investors will worry about higher inflation because the Fed has conditioned market participants to believe that low unemployment produces faster wages, which in turn generates higher prices.

This is despite the fact the historical record strongly suggests otherwise. In other words, the scenario that we envision for this year, stronger productivity gains that lead to stronger wage gains, should be embraced and not feared.

Hopefully, soon-to-be new leadership at the Federal Reserve (i.e., the Fed) recognizes this. Against a backdrop of non-inflationary growth, official interest rates should rise only modestly this year. If so, this would likely keep the economy on a solid growth path, thus extending the length of the business cycle.

Joseph LaVorgna is the chief economist for the Americas for Natixis, a French corporate and investment bank. LaVorgna was ranked as the No. 2 most influential economist in 2013 by The Wall Street Journal. He is a long-time contributor on CNBC.