Tuesday, October 28, 2014

Wages, Inflation, and Interest Rates in the Recovery

It seems reasonable that as the recovery ages, sticky wage issues would be less of an issue.  I have seen the problems of low inflation more as an ingredient regarding frictions in short term savings and investment and in the residential real estate market, which remains underpriced and over-leveraged.  But, looking again at some graphs on wage growth, I'm not so sure that they don't still signal a continuing wage floor.

Here is a graph of nominal YOY wage growth.  In the last several cycles, wage growth has dropped down to about 2-3%, but never lower for an extended period of time.  Normally, this measure is in constant flux over a business cycle, but in the early 1990's and again since 2010, it has moved down to a low, slightly positive level and remained there for several years.  This seems like a classic indicator of a natural price floor.  After 5 years, wage growth is still moving sideways.

Here is a graph of real YOY wage growth.  Note that when nominal growth is above 2%, real growth can drop well below 0% during cyclical shocks.  But the nominal floor around 2-3%, combined with low inflation, has kept wage adjustments from dropping as much in the more recent cycles.

This suggests that a little more inflation could help labor markets, and that disinflation now might be damaging.  On the other hand, with unemployment now falling into the 5%'s, real wage growth might be expected to be strong enough to escape the floor without the help of inflation.

Here is a messy graph comparing wage growth, inflation, home market value growth (right scale), and interest rates.  All in all, this lifts my spirits a bit, regarding cyclical issues over the next year.

Recoveries in wages and fixed income markets in the "Great Moderation" period have not necessarily correlated with inflation rates that closely.  Most cyclical fluctuations in wage growth have been real.  In the late 1980's and the 2000's, half or more of the change in nominal wage growth rates from the nadir to the peak was real.  In the 1990's, inflation was dropping throughout the recovery.  Total home market values were growing at a moderate pace during the 1990's recovery, as I fear they will now without further accommodation.  The 1990's pattern suggests that changes in real wage growth can remain strong under the conditions I fear.

As far as interest rates go, I see them as more of a market phenomenon than a Fed phenomenon, although the Fed dominates in the very short term at the short end of the yield curve.  But, if the market for real short term rates tops out at 1%, the Fed target will top out there, too.  If wages show sustained increases in growth rates, we might expect short term rates to begin to rise.  And, if they are going to rise, an increase of 2% to 3% within a year of the initial hike would be typical.  I don't know if there is very much room for the first hike to shift back in time.  Prime speculative positions in forward rates probably are still in the 2016-2017 contract periods, and would gain more from gains in subsequent rates than from the change in the date of the first hike.

But, if inflation continues to moderate, it might be possible that we are basically in 1994 right now.  If the tightening of the end of QE3 is the equivalent of the rate hikes of 1994, and real short term interest rates are topping out at less than -1%, then zero nominal short rates might be the terminus Fed policy.  Just as in the 1990's, we could see rising wages in a low inflation context.  In fact, as the housing market slowly deleverages, we could see a very slow acceleration in total home market values as we did in the late 1990's.  There could be a very long, very strong commercial & industrial economy for another 5 years in that scenario, with strong wage growth until some bump in inflation well in the future causes a follow-up tightening in Fed policy, like in the late 90's.

I'm probably a broken record on this (a scratched CD for my younger readers), but the difference between those two interest rate scenarios is probably a product of real estate credit markets.  Depending on what happens there, the Fed Funds rate in 2017 will probably be either 0% or 3%, with not much chance of anything in between.


  1. Check out recent reports from Bain & Co. regarding global capital gluts. The new normal maybe negative interest rates.

    1. Are there any links you can give me, Benjamin?

    2. TravisV here.

      Google "Benjamin Cole" and "A World Awash in Money"

      Also see this comment on a PWC report Benjamin posted on Scott Grannis's blog:


    3. Thanks, Travis.

      It certainly seems like an issue suited for market monetarism to solve....