Wages are the Central Issue for 2018

Written by Richard Hokenson 

The Fed is projecting further increases in interest rates because they believe that the economy is very close to full employment - wages should begin increasing any second now which will lead to higher price inflation. Our view is that there is still considerable labor force slack which will continue to translate in modest wage inflation. This is confirmed by the relationship between the unemployment rate and wage growth as measured by the Employment Cost Index (ECI). Wage inflation has hardly budged despite a substantial decline in the unemployment rate (see Chart 1). The same pattern is also evident in Average Hourly Earnings (AHE), which recorded a deceleration in 2017 (see Chart 2). A similar deceleration was also evident in the Atlanta Fed’s Wage Growth Tracker – 3.3% for 2017 versus 3.5% in 2016. We are also encouraged by the fact that nearly every day there is a news story regarding firms recruiting employees that had been passed over before, e.g. those with prison records. Barring any shocks to labor supply, e.g. bigger declines in the number of foreign born workers, we remain of the view that wage inflation will remain moderate in 2018.

Price Inflation

With respect to the outlook for core CPI inflation, several commentators are forecasting higher price inflation in 2018 based at least in part on the observation that the “base effect” will help, i.e. when the March 2017 decline, which partially reflected mobile phone prices, drops out. Left unsaid, however, is the fact that the monthly increase in the core CPI was lower in 7 of the remaining 9 months of 2017 (see Chart 3). While it is true that the March dip caused the core CPI inflation rate to drop from 2.22% in February to 2.00% in March, the cumulative effect of the remaining months carved out another .22% from the inflation rate as measured yearon- year (see Chart 4).

While it is very likely that the results for March 2018 will show a higher year-on-year change compared to February, the actual result is apt to disappoint relative to current expectations. Last but certainly not least with regards to the outlook for inflation is the fact that there is now a strong rebound in productivity (see Chart 5) which is resulting in a decline in unit labor costs (see Chart 6). Yet another reason to be sanguine regarding the outlook for inflation this year.

Outlook for the Fed

In the belief that higher wage inflation was just around the corner and that the weakness in inflation was transitory or a flue, the Fed raised interest rates three times last year. That belief, however, will certainly be tested if wage growth remains moderate and price inflation does not spike up. Will they stick to their plan for three increases this year or will continued moderation result in a different appraisal? We hope for the latter.


This update was researched and written by Richard Hokenson, as of January 18 2018