Research Note: A Closer Look at Wage Growth

October 31, 2017 | Market Commentary

October marks the eight-year anniversary of the first and only month since the early 1980s that headline unemployment reached 10% in the United States. A lot has changed in the intervening eight years. The unemployment rate for September 2017 sits at just 4.2%, and labor market slack has diminished materially over the past several years. Meanwhile, headline wage growth has so far remained relatively subdued, despite signs that employers increasingly need to compete for qualified workers. Wage growth can have significant implications for not only consumers, but also for costs of production, which can impact the prices of finished goods and services (i.e. inflation) as well as corporate profits (i.e. the business cycle).

However, headline wage growth is a lagging indicator. Thus, it is important to understand how latent employment dynamics may affect headline wage growth going forward. This research note takes a deeper dive into these labor market dynamics and highlights some of the factors we are closely monitoring for signs of upward wage pressure.

Starting in 2012, there has been a steady stream of workers entering full-time employment and a commensurate decline in the share of workers employed part-time for economic reasons (chart below). This is not an uncommon pattern for the later stages of an economic cycle. As the labor market strengthens, workers move into full-time employment from unemployment, part-time employment, or outside of the labor force entirely. While this is likely a favorable change for individual workers entering full-time employment, this can also act as a drag on headline wage growth because new entrants to full-time employment tend to make below average wages.

The Federal Reserve Bank of San Francisco recently published a report that examined the impact of this compositional shift on wage growth. The chart below shows the estimated drag on median earnings growth from the movement of workers into and out of full-time employment. By their estimate, these flows pulled wage growth down by a little under 2 percentage points per year from 2012 to 2015. Recently, though, this effect has moderated slightly. With much of the supply of workers unemployed or employed part-time for economic reasons now exhausted, it is likely that this drag will continue to fade.

The aging of the U.S. population is another more secular compositional shift that has pulled down headline wage growth. The baby boomers have moved into the later stages of their careers and toward retirement, bringing the share of workers 55 years and older to the highest level in the near seventy-year history of the data series.

An aging workforce affects wage growth through two channels. First, workers in older cohorts tend to experience lower wage growth. A study from the Federal Reserve Bank of New York estimated life-cycle real wage profiles within 140 demographic cohorts, controlling for seasonal and business fluctuations. Within a given cohort, the typical worker experiences rapid wage growth early in their career, potentially due to on-the-job learnings and improvements in matching that worker to a job. This growth gradually levels off as the worker gets later into his or her career until real wages eventually decline. This decline may be explained by a diminished incentive for the worker to invest in new skills or to change jobs. The chart below is for several cohorts of white males born in the 1950s, but the results were consistent across all cohorts examined.

Although older workers tend to experience slower wage growth, the absolute level of their earnings is typically higher. As large swaths of high-earning baby boomers retire, they are replaced with lower-earning workers closer to the beginning of their career, a transition that also pulls down aggregate wage statistics.

One way to remove the effect of these compositional changes is to look at the wage growth of matched individuals. Traditional wage growth aggregates present the earnings of the average worker at a given point in time, and this “average worker” may vary between different periods as the composition of the workforce changes. Conversely, a matched sample allows for the examination of growth in earnings for a particular worker between two periods, resulting in a more apples-to-apples comparison than in traditional earnings metrics. The Atlanta Fed Wage Growth Tracker presents the median percent change in the hourly wage of matched individuals observed twelve months apart. Using this methodology, there are more signs of life in aggregate wage growth.

There has also been an acceleration in wage growth in some intriguing cohorts. Although wage growth for workers over 55 remains muted, growth for younger workers is nearing the levels experienced in the later innings of the most recent cycle. Additionally, over the past two years, low-skilled workers have finally enjoyed more robust wage growth after several years of depressed growth.

While traditional wage growth statistics can help to give a picture of labor costs employers are facing, compositional shifts in the labor force can obscure information that helps gauge the underlying strength of the labor market. The data from the Atlanta Fed Wage Tracker suggest that many workers are now experiencing relatively robust wage growth. Although this has not yet triggered meaningful inflation, history shows us that wage growth can accelerate quickly once labor market slack is exhausted. Additionally, while the wage growth drag from the baby boomers will persist for some time, the diminished supply of part-time and unemployed workers means the drag from workers moving into full-time employment will likely fade.

As outlined in our U.S. Labor Market Monitor, several metrics show that labor market slack has significantly diminished over the past several years. Some employers may continue to find alternatives to raising wages, such as outsourcing abroad or increasing automation. However, survey data suggest that these outlets are currently not sufficient to fully relieve the labor market tightness. Thus, while wage growth has not yet been robust enough to lead to meaningful inflation, several factors suggest that a further acceleration in wage growth in the short-to-intermediate term should not be ruled out.

Labor market tightness and accompanying wage growth is normal for an economy that continues to move later into the cycle, and does not pose an imminent risk to the current expansion. However, given the important implications wage growth has for the economic outlook, the underlying strength of the labor market and characteristics of wage growth warrant continued monitoring.

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