US Labor Market: More Jobs, But Little Wage Growth
Despite a substantial decline in the US unemployment rate since 2010, nominal wage growth has remained remarkably steady around 2 per cent over the past two years.
The US central bank, the Federal Reserve (Fed) has two main targets – maximum employment and price stability. Hence, the assessment of the remaining slack in the labor market and the associated outlook for wage inflation are key factors determining the Fed's monetary policy, and in particular the Fed's decision of the timing of the first rate hike.
In the March meeting, the US Fed's Open Market Committee (FOMC) lowered its median forecast for the long-run unemployment rate (or Non-Accelerating Inflation Rate of Unemployment, NAIRU). The downward revision in the NAIRU, the unemployment rate that is consistent with stable inflation, implies that the FOMC still sees significant slack in the labor market. This suggests the Fed is not expecting much upward pressure on inflation – in fact the FOMC members also lowered their inflation forecasts.
Unemployment Rate Likely to Decline Further
In a recent Research Alert we showed that broader labor market measures, such as the degree of underutilization (U6 unemployment) still signals remaining slack in the labor market. Despite substantial improvement, this composite measure, which includes the number of (wholly) unemployed people as well as those who only find part-time work and the so-called "marginally attached" (not actively searching for a job, but are willing and able to work), remained well above pre-recession levels.
Overall, we estimate that around 2.5 million additional people could return to the labor force if the current cyclical upswing holds up. The highest potential to return back to the labor market have those who are marginally attached and those who are currently in education, number of which jumped during the recent recession well above the secular trend. Assuming a gradual re-entry of these individuals over the next two years, we estimate that the unemployment rate will decrease further from the current 5.5 per cent to 5.2 per cent at the end of 2015 and 4.7 per cent at the end of 2016.
Subdued Wage Growth so Far
Fundamentally, wage growth and unemployment should move in opposite directions, since a tighter job market raises the bargaining power of workers, which implies high wage growth pressure. However, despite substantial decline in the US unemployment rate since 2010, nominal wage growth as measured by average hourly earnings has remained remarkably steady around 2 per cent over the past two years, failing to show a significant increase. Several reasons can explain the subdued wage growth.
Employment Gains Mostly in Low-Wage Sectors
A lion's share of non-farm employment growth in the periods 2013-14 comes from labor-intensive sectors such as leisure/hospitality and retail trade. However, since these sectors do not require specific skills, the labor force employed in these sectors has only low bargaining power, which implies low wage growth. The labor flows into the low-paying jobs were likely additionally supported by the Congress's decision (as of December 2013) to reduce the length of time in which unemployment benefits are paid, since the formerly unemployed who lost benefits were likely willing to accept lower wages.
In contrast, the highest wage levels and wage growth were recorded in high-skilled sectors such as financial services and IT, which contributed only to a limited extent to employment gains. Overall, since a considerable share of jobs was created in around average-wage level sectors, such as professional services and education, the subdued wage growth cannot be assigned solely to job creation in low-paying segments.
Downward Wage Rigidity Weighed on Wage Dynamics
Another explanation for the subdued dynamics of wage growth during the ongoing recovery is the downward rigidity of nominal wages. During times of weak economic growth, workers are reluctant to accept wage cuts and employers are unable to reduce wages. This leads to a significant build-up of "pent-up" wage cuts, which weighs on wage growth long after unemployment starts to return to normal levels.
Will Wage Inflation Pick up in 2015?
Given the projected further decline in the unemployment rate, a gradual build-up of wage pressure in 2015 appears likely. However, we expect the path of wage growth to stay lower than in past cycles. One of the main constraints on wage growth is the still subdued labor market "fluidity" (as measured by the number of worker flows between employers). This can also be seen in the ratio of hires-to-job openings, which has declined substantially since 2010, and has so far remained at historically low levels (see figure). The latter points to weaker-than-usual confidence on the part of employers as well as remaining labor market slack. At the same time, workers are still reluctant to change to a better suited job. Since switching employers offers a possibility to bargain for higher wages (particularly for younger workers), a lower reallocation rate hampers wage growth.
The historically low labor productivity growth is the second roadblock to faster wage growth. A low reallocation rate dampens labor productivity growth through diminished "creative destruction" and factor reallocation, which are important contributors to innovation.
Given the factors citied earlier, current labor market conditions indicate that the Fed will likely proceed cautiously and on a slow trajectory toward policy normalization. We expect the first rate hike in September 2015.