Is wage growth really going to stoke inflation?
Every month when labour market data is published in the US or the UK, the main focus of investors these days is not on the actual number of jobs created but on the increase in wages. Most recent data show that average hourly earnings in the US in September have risen 3.1% compared to the year before, while in the UK average weekly earnings increased 2.7%. This may sound like healthy wage growth (or at least that is what pundits on TV claim it is), but if we compare it with local inflation data then we see that real wage growth is rather low. Real wage growth in the US has been 0.5% and in the UK 0.3%. Nevertheless, at least real wage growth is positive once again after years of declining real wages in both countries.
Theoretically, this higher wage growth should filter through into higher inflation as businesses pass on higher wage costs to consumers, but since the 1980s this wage-price spiral has proven increasingly elusive. Our chart shows the rolling five-year correlation between quarterly increases in unit labour costs and inflation one quarter later. With the exception of the disinflationary period in the early 1980s, this correlation has always been around 0.5 from the mid-1960s to the late 1980s. But since then, the correlation between wages and inflation has increasingly weakened and has hovered around 0.0 since the late 1990s.
The discussion about inflation threats depends crucially on the future development of this correlation. Central bankers and investors, who are worried about the spectre of rising inflation in coming years to some extent bet on this correlation rising to levels that more closely resemble the 1980s than the last twenty years or so. If that were not the case, then the only way to create meaningful inflation would be with another long-lasting commodity boom or a depreciation of the US Dollar or Sterling leading to import price inflation.
Proponents of a Japan-style deflationary future, on the other hand, must rely on the correlation between wages and inflation to remain stable at current levels or, alternatively, assume that wages will continue to decline in real terms for years to come – a development that might have political or social consequences that we can see in the rise of populist governments everywhere these days.
As far as I am concerned, I am on the fence between these two scenarios. At the moment, our main scenario is one of low inflation that is rising very moderately but always remaining well within shouting distance of 2%. However, there is an increasing risk of policy failure where populist fiscal policies or lax monetary policy is going to create a 1970s style stagflationary world. This is so far a risk scenario, but the more we watch the developments in the US, Italy and other countries, the higher the likelihood of such a scenario seems to become.
Five-year rolling correlation between wage growth and inflation
Source: Bloomberg.