In pre-Covid US, the unemployment rate had fallen to near 50-year lows and yet inflation and unit labour costs remained subdued;
aging of the population will continue to weigh on participation going forward,
wages have accelerated over the years,
and wage growth has been firmer at the bottom end of the wage distribution.
Powell, in his June FOMC press conference said that the pandemic has seen many placed on ‘temporary layoff’ who are now finding themselves having to find new jobs as the recovery is under way. He said, “in particular, despite progress, joblessness continues to fall disproportionately on lower-wage workers in the service sector and on African Americans and Hispanics”, a statement that reiterated the shift of Fed’s employment focus on max employment, defined as “broad and inclusive”.
Whereas in Europe, workers’ support concentrates on preserving existing employment relationships through wage subsidies, the US system abruptly forces temporary layoffs, which may also turn into permanent ones as relationships and ties with former employers weaken over time.
This is a highly efficient system if post-Covid the US economy is to go through major structural changes such as large sector reallocations. However, this system becomes a problem if the shape of the economy remains the same as pre-Covid as it introduces further stickiness and major search costs.
Although the US labour demand appears resilient, almost 4 million people cited Covid as their reason for not looking for work and around 1 million went into early retirement. According to a Goldman report, the disproportionate layoffs of low-wage workers have led to an upward “composition bias” in series such as US average hourly earnings. Moreover, furlough schemes have transferred labour costs from firms to governments, which has artificially reduced compensation per employee.
Covid’s impact on inflation depends on the relative sizes of the supply and demand shocks.
In the same June press conference, Powell also mentioned that supply shocks narrow short-run productive capacity, leading to lower real activity and higher inflation. Some argue that this may persist much longer than the word ‘transitory’ implies. However, for transitory effects to turn into more persistent effects on the inflation rates, the price increase would need to substantially change inflation expectations, thereby starting a spiral of wages to prices and prices to wages increases.
I saw today that Powell said that inflation expectations are not at troubling levels. It’s good to know then that the institutional stability our modern times has built works, ensuring (so far cross fingers) that unanchoring of expectations doesn’t happen abruptly or out of the blue.
Subsequently, there might be downward pressure on wage growth due to output gaps, given wage stickiness and lags in the Philips curve. If we manage to get Covid properly under control faster than expected, this could also push wage growth down. The return of low-wage workers would also reverse the upward composition bias mentioned above. Increasing slack significantly reduces wage growth.
As a rule of thumb, a 1 pp fall in the unemployment rate gap (decrease in slack) raises wage growth by 0.3-0.4 pp. In the modern era of low and stable inflation expectations, unemployment rate has a statistically highly significant and very robust effect on wage growth.
Having said that, wage growth is not necessarily inflationary. This may be explained by the labour market structure. A greater coverage of collective bargaining is associated with higher pass-through from wages to inflation and the US has lower pass-through compared to Europe.
EightAteEight 