Mr Phillips is resting

Markets are increasingly concerned that central bankers may be about to take away the punch bowl rather earlier than they had previously anticipated. The Bank of Canada was the latest central bank to tighten policy, raising rates by 25 bps this week for the first time since 2010. There is also increased nervousness regarding the policy intentions of the ECB and BoE. But whilst there are good reasons for taking away some of the emergency easing put in place in the wake of the financial crash of 2008-09, it is proving much harder to justify tightening on the basis of inflation than most had expected.

This is a particular problem for the Fed which has nudged up the funds rate in four steps of 25 bps over the past 18 months, but is reliant on signs of higher inflation to justify ongoing policy normalisation. US core CPI inflation, which was running above the Fed’s 2% target rate last year, slipped back to 1.7% in May and June and is thus at the bottom end of the range in place since 2011. Wage inflation has also picked up, but here too the acceleration has been modest, with hourly earnings running at an annual rate of 2.8% in June which is only 0.5 percentage points higher than the average of the last three years.

For an economy which is running close to what appears to be full employment, this might appear rather surprising. But the headline unemployment rate, currently 4.4%, understates the degree of slack in the US labour market. The so-called U6 rate which adds in “marginally attached” workers – defined as “those who currently are neither working nor looking for work but indicate that they want and are available for a job and have looked for work sometime in the past 12 months” – is still at 8.6%. This is slightly higher than the previous cyclical trough in 2007 when it reached 8.0%, and significantly above the low of 6.8% recorded in October 2000. Arguably, therefore, the jobless rate can still fall a little further before wage and price inflation starts to become more of an issue.

The UK shows a similar – indeed, perhaps more extreme – picture with the unemployment rate in the three months to May at its lowest since 1975 whereas the rate of wage inflation, at 1.8%, is a full percentage point below that recorded last November. As in the US, there is a significant amount of spare capacity in the labour market. Currently, 12% of those working in part-time employment are doing so because they cannot find full-time employment. Whilst this is down from a peak of 18.5% in 2013, it is still higher than the 8-9% range recorded before the recession of 2008-09 and points to a certain degree of involuntary underemployment. This in turn suggests that there have been structural changes in the labour market which have impacted on the traditional relationship between headline unemployment and wage inflation.

For many decades, economists have focused on the negative relationship between wage inflation and unemployment first postulated by Bill Phillips in the 1950s. In its simplest form, this suggests that policymakers face a trade-off between unemployment and inflation. In practice, the relationship holds only in the short-term, if at all. What is notable, however, is that in the UK and US there has been a flattening of the curve in recent years, suggesting that any negative relationship between wages and unemployment is even weaker today than in the past. 

This is illustrated for the UK in the chart below, based on an idea presented in Andy Haldane’s recent speech entitled “Work, Wages and Monetary Policy.” The chart shows the trend derived from a linear regression of wage inflation on the unemployment rate over various periods. Two features are evident: Most obviously, the line has moved down reflecting the fact that over time inflation in the UK has fallen. But it is also notable that the slope of the line has become shallower. In other words, UK wage inflation has become less sensitive to changes in the unemployment rate. To illustrate the implications of this, we assess the wage inflation rate consistent with an unemployment rate of 5.5% and how this would change if unemployment fell to 4.5% (current levels).

The results are shown in the table (below). Simply put, an unemployment rate of 5.5% would be associated with wage inflation of 14% on the basis of the relationship over the period 1971-1997, falling to 4.1% between 1998-2012 and just 2.1% on the basis of the data for 2013-2016. But what is also interesting is a one percentage point fall in the jobless rate to 4.5% has a much smaller impact based on recent years’ data than in the pre-recession period. For example, this might have been expected to produce a 0.9 percentage point rise in wage inflation over the 1997-2012 period compared to a 0.5pp rise based on recent data.

Space considerations preclude a look at the reasons for the weaker sensitivity of wage inflation to labour market conditions. It may be the result of factors such as a lower degree of unionisation; the more widespread use of zero hours contracts and the rise of the gig economy, all of which have raised the degree of slack which the headline unemployment rate does not capture. But what the analysis does suggest is that policymakers can afford to spend less time worrying about the impact of low unemployment on wage inflation. There may be a case for higher interest rates but it is not to be found in the labour market.

As a final thought, I am struck by certain parallels with Japan. Following the bursting of the bubble economy, the Japanese authorities failed to spot the structural factors which led the economy to the brink of deflation, notably an ageing demographic profile which prompted a switch towards saving rather than consumption. The one factor we might be missing today is the impact of automation, which threatens a significant substitution of capital for labour and which could put downward pressure on the relative price of labour. I would thus not be in a hurry to raise interest rates to counter a wage inflation threat which has so far failed to materialise.