25 Aug. 2016 | Comments (1)
We are now more than 7 years since the end of the Great Recession and, while most labor market indicators point to an economy near full employment, some notable measures of wage growth remain weak. As a result, there has been a lively debate in the past year about what is behind the slow growth in wages. Some argue that the labor market is still far from full employment. Others argue that the relationship between labor market tightness and wage growth is no longer as strong as it used to be.
In contrast, in this blog we show that current wage growth is actually very much in the range of what one should expect given current economic conditions in the US.
Chart One: 4 quarter growth rates in wage measures
Sources: BLS and Atlanta Fed
We estimate what wage growth should have been in the past 4 quarters given economic conditions in the US and then compare the estimate to the actual wage growth rate. We focus on three measures of wage growth:
- The Employment Cost Index (wages and salaries)
- Average hourly earnings (Establishment Survey)
- The Atlanta Fed Wage Growth Tracker, which measures hourly wages of continuously employed workers.
We do this by estimating with regressions the different measures of compensation growth (four-quarter growth rate) using several determinants of wage growth:
1) Labor Market Tightness – To measure the impact of labor market tightness we use the unemployment gap, which subtracts the natural rate of unemployment from the current rate of unemployment. In our estimation, we allow for the impact of the unemployment gap on wage growth to vary according to whether the unemployment rate is below or above the natural rate. A recent paper by the Dallas Fed1 finds that as long as the unemployment rate is above its long-run average, tightening of the labor market does not have a big impact on wage growth. However, when the unemployment rate starts to drop below its long-term average, the impact on wage growth becomes significantly stronger.
2) Involuntary Part-Time Workers – Since labor market tightness may not be entirely captured by the unemployment gap, we add another variable that complements the unemployment gap in estimating labor market tightness. Involuntary part-time workers are those who want a full time job, but had to settle for a part-time job. We use the share of involuntary part-time workers as part of our "part-time" work total.
3) Inflation – When inflation is higher, wage growth tends to be higher, as employers need to compensate workers for the increase in cost of living. To capture inflation we separately use the core consumer price index and the core deflator of personal consumption expenditure.
4) Productivity growth – The faster the growth in labor productivity, the faster the growth in the contribution of the workers to their employers.
Our results were based on two sample periods: The first starting in 1988Q1 and the other in 1998Q1. Both samples end in 2016Q2. Chart two below reveals the actual 4 quarter growth rate ending in 2016Q2 versus an average of the estimates for this period across estimation specifications.
Chart two: Average estimate versus the actual wage growth
What do the results show?
The estimates are not that different from the actual growth rate. This suggests that given economic conditions we should expect current wage growth to be low. Why?
1) The labor market is still not very tight. According to the CBO, the unemployment rate is just now reaching its natural rate and the number of involuntary part-time workers is still above normal. Our results confirm the Dallas Fed paper and show that wage growth tends to accelerate when the unemployment rate goes below its natural rate.
2) Inflation has been low in recent years, which lowers wage growth.
3) Growth in labor productivity has been unusually low in recent years. In fact, productivity growth in the past four quarters has been negative.
With low inflation and productivity growth, and with the labor market just beginning to reach the full employment range, we should expect wage growth to still be low at the moment.
But that is not the entire story. According to the ECI and the establishment survey (as shown in Chart 2), actual wage growth is below the estimate. However, the Atlanta Fed wage tracker reveals that actual wage growth is slightly above the estimate. What could explain that difference?
First, we need to better explain why the Atlanta Fed measure is different than the ECI or establishment survey. While the other measures calculate average growth for all workers, the Atlanta Fed measure tracks wage growth for the same individuals over a 12 month period. It is, therefore, immune to the impact of changes in the composition of employed workers. Thus, the impact of changes in composition is negative, as high-wage experienced workers retire and young inexperienced and low-wage workers enter the labor market.
Chart one show that, in recent quarters, the recovery in the Atlanta Fed measure is especially strong and Chart two shows that it is, in fact, not at all growing below what we should expect it to grow. Researchers from the San Francisco Fed show that the negative compositional impact is especially large in recent years, simply because the number of retirees is unusually large due to the size of the baby-boom generation. In addition, as a result of the Great Recession, the number of low-wage workers taking new full-time jobs has also been especially large.
What are the implications of these results?
First, as the San Francisco Fed authors suggest: “…sluggish wage growth may be a poor indicator of labor market slack. In fact, correcting for worker composition changes, wages are consistent with a strong labor market that is drawing low-wage workers into full-time employment.”
Second, inflation is likely to accelerate a little in the coming quarters when the impact of low oil and commodity prices and the strong Dollar begin to ware off. That may put some upward pressure on wage growth.
Third, productivity growth has nowhere to go but up. That may put some upward pressure on wages as well. Even with the current low wage growth, since productivity growth is so low, that unit labor cost, one of the main determinants of profits, is growing rather fast, thus lowering corporate profits.
In sum, wage growth has not been weaker than what one should have expected it to be, and it is likely to get stronger in the coming year.
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