Memo to the Fed: Higher wages won't cause higher inflation

Memo to the Fed: Higher wages won't cause higher inflation
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The January employment report showed a solid 200,000 increase in nonfarm payrolls. At the same time, the unemployment rate remained steady at 4.1 percent for the fourth month in a row.

However, average hourly earnings rose more than expected, pushing its year-over-year rate up to nearly 3 percent, a new cyclical high. Additionally, the nonfarm workweek declined sharply, which has negative implications for current quarter real GDP growth.

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However, this could be due to unseasonably cold weather, so a rebound is expected. If it does not happen, Q1 real GDP will be weak for the fifth time in the last six years.

 

In the details, the gain in January employment was broad-based, as both the good-producing (57,000) and private service providing (139,000) sides of the economy generated jobs. Government payrolls expanded by a scant 4,000 after declining for four months in a row.

In fact, there were not any major sectors of the labor market that lost jobs last month. This is consistent with historically low layoffs that are evident from the weekly jobless claims data. Economic breadth is a sign of vitality, so solid job gains are likely to persist for the foreseeable future.

While the unemployment rate was steady, the broader U-6 measure of labor slack edged up a negligible one-tenth to 8.2 percent. Last year, the economy grew 2.5 percent, and the unemployment rate fell 60 basis points. So, if real GDP growth is 3 percent this year, then the unemployment rate is likely to fall at least as much and possibly more.

This could engender concerns about inflationary wage gains — i.e., the Phillips curve, which posits a trade-off between unemployment and inflation. We are not likely to see a meaningful rise in inflation though.

At this point in the business cycle, it is normal for companies to find efficiency gains when the labor market is this tight. It happened in the late 1990s when unemployment and inflation were at similar levels, and the economy never experienced an inflation flare-up.

Furthermore, the recently passed tax reform bill should be a boon for capital spending. In other words, we are going to get growth in an area of the economy, technology, which typically does not show much inflation.

Additionally, our expectation of a capital intensive boost to real GDP growth should help increase the economy’s underlying capacity. This is inherently disinflationary.

However, in the short-term, financial markets may overestimate inflation risks, in large part because the Fed has conditioned investors that the Phillips curve will re-establish itself at some point. If productivity and labor force growth improve, the Fed has little to fear.

In Q4 2017, productivity fell 0.1 percent, but this was after a 2.7-percent increase in the previous quarter. Prior to Q4 2017, the year-over-year trend in productivity growth was trending higher. It rose from 0.8 percent in Q4 2016 to 1.4 percent by Q3 2017 before settling back to 1.1 percent last quarter.

Our best guess is that efficiency gains and capital deepening can push the year-over-year rate of productivity growth up into the 1.5- to 2-percent range for at least a year, perhaps longer. A step-up in labor force growth is likely, too.

The civilian labor force expanded nearly 1 percent in 2017, but it could grow a bit faster this year as discouraged workers re-enter the job market. This is likely because the U-6, which is the broadest measure of labor slack, is still over one full percentage point above where it was in the past when unemployment was around 4 percent.

Productivity in the 1.5- to 2-percent range coupled with labor force growth in the low ones essentially puts us pretty close to 3 percent real GDP growth.

Under the above scenario, the unemployment rate drifts lower while at the same time, wages (because of rising productivity) drifts higher. For some monetary policymakers and market practitioners, this will feed the narrative of budding price pressure.

These inflation impulses should be resisted. Already, the futures market has priced in another 100 basis points of tightening, leaving it only one and half hikes short of the Fed’s estimate of the terminal rate. If the Fed becomes more meaningfully hawkish, the yield curve can invert. This would disintermediate the financial markets and ultimately put a brake on economic activity.

To be sure, the recent sell-off in global stock markets, while admittedly long overdue, has largely been the result of the sell-off in global bond markets. The latter is largely the result of fears that stronger economic activity, stoked by the January U.S. employment report, will engender a wage-led flare-up in inflation.

This narrative, which is rooted in Phillip curve, should be strongly resisted by incoming Fed head Powell and his colleagues. If not, then monetary policymakers run the risk of aborting an economic expansion that this still has room to run.

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.