In this note we explain why we have not taken any signal from today’s AHE number, where wage and total compensation growth stands according to our common wage model, some important results from the literature, and how this fits in the Fed staff framework and forecast.
Keep in mind
The main message is the same of the last few months: wage growth remains way above the level consistent with the Fed target and there is little in the data that suggests wage growth is moderating. Risks are skewed to the upside, especially in the medium-term. Recent academic literature supports this view.
An important note
We have not taken any signal from today’s deceleration in AHE growth for two reasons:
1) Monthly AHE figures are distorted by calendar effects (see BLS here), meaning that months with higher number of weekend days are associated with stronger wage growth (in August, the number of weekend days was 8, the lowest possible). Without entering into the details of why this “residual calendarity” effect exists, here are two possible explanations. First, wages of hourly workers tend to be higher during the weekends so the higher the number of weekend days in a given month, the higher the AHE level in that month. Second, the denominator (hours) can biased if employers report fixed wages across months for salaried workers but different hours depending on the number of working days. While the BLS procedures account for seasonal effects, they are unable to remove entirely this calendar effect. The final result is that, as mentioned, months with higher number of weekend days tend to have higher AHE MoM growth rates. For this reason, it is unsurprising that AHE growth was strong in July (which included 10 weekend days) and we do expect a very strong number in October (which contains 10 weekend days).
(Note: in our experience the Fed staff is well aware of the “residual calendarity” effect in the AHE series and in our view has discounted the “softness” in today’s data).
2) More in general, the summer data of AHE are hard to comment. For instance, last year AHE grew 3.6% (MoM, a.r.) in August but in July and September it grew at a much faster rate (6.1% and 6.4%, respectively).
Therefore, given the above and the evidence from other indicators (i.e. Atlanta Fed wage tracker) we have discounted today’s AHE reading entirely.
Results of our common wage model
We have updated our mixed-frequency Dynamic Factor Model (DFM) of “common wage” based on today’s release of the Average Hourly Earnings (AHE). Today is the first time we include 2022:Q3 in the sample. The BLS report showed solid wage gains: in August, average hourly earnings for all employees (production and non-supervisory employees) on private nonfarm payrolls increased at an annual rate of 3.8 (4.4) percent.
Our common wage measure took signal from the currently available Q3 data and revised up recent history marginally. The estimated level of the common wage factor is at 5.7% in Q3 (Figure 1). The current level is way above the pre-Pandemic and it is now the highest in the sample (which starts in 1982). Finally, it is way too early to say something about the second derivative of the common wage. Therefore, we defer the discussion about possible moderation in wage growth when we will have some evidence.
Implications for the Fed staff
The main takeaway is that current wage (and total compensation) growth continues to be well above the fundamentals: underlying inflation and structural productivity. (please, refer to our “Pre FOMC Meeting Package” for the relevant chart). In other words, the risk of a passthrough from wages to price inflation continues to be very high. Taken at face value, the current readings of the common factor would imply a level of (underlying) core PCE price inflation of about 4%. In other words, wage growth is inconsistent with the Fed target and continues to point to upside risks in the medium-term.
All told, little to celebrate on the wage front for the Fed staff at the moment. For this reason, we expect the Fed staff to continue to convey the same message of the last few rounds: the FOMC cannot exclude there is some form of spiral from wages to core inflation (especially services) at the moment. Therefore, the chances of a Fed pivot appear limited right now.
Recent literature on wage growth
Recent research supports the view that nominal wage growth represents an upside risks for consumer price inflation. The positive news is that labor supply is starting to show encouraging signs (see NY Fed note #3 on this point).
Here are the main findings of recent academic-style research:
1) A SF Fed note titled “Will Workers Demand Cost-of-Living Adjustments?” by Glick, Leduc and Pepper argues that wage inflation is sensitive to movements in household short-run inflation expectations but not to those over longer horizons. The authors argue that this points to an upside risk for price inflation next year, as workers negotiate higher wages that businesses could pass on to consumers by raising prices in the next several months. (for the record, the authors’ estimates suggest current household one-year-ahead expectations could add nearly 2.3 percentage points to wage inflation going forward, a substantial upside risk to price inflation).
2) A NY Fed note titled “Pass-Through of Wages and Import Prices Has Increased in the Post-COVID Period” by Amiti et al. shows that the pass-through of wages (and input prices) to the U.S. Producer Price Index has grown significantly during the pandemic. According to the authors’ estimates, a 10 percent increase in wages in the non-tradable (tradable) sector was associated with a 0.7% (0.1%) increase in producer prices but it is now associated with a 2.4% (1.4%) increase. The authors conclude that the wage growth channel is an important driver of US domestic prices.
3) A NY Fed note titled “Pandemic Wage Pressures” by Benigno and Pelin shows that wage pressures are highest in the sectors with the largest employment shortfall relative to their pre-pandemic trend path, but that other factors explain most of the wage growth differentials. In other words, the authors show that the recent acceleration in nominal wage is associated with pandemic specific factors. For this reason, the authors conclude that the rebalancing of the labor market could be restored from the supply side as employment return towards pre-pandemic levels rather than the demand side by reducing the number of vacancies.
Figure 1. Common Factor across measures of wages and total compensation
Note: the Figure shows four measures of wages and total compensation, as well as the estimated common factor from our Dynamic Factor Model. ECI stands for “Employment Cost Index, Total Compensation, Private Industry, All Workers, SA”. AHE stands for “Average Hourly Earnings, All Employees, Total Private, SA”. CPH stands for “Nonfarm Business, Hourly Compensation, SA”. AFWT stands for “Atlanta Fed Measure of Median Nominal Wage Growth, Unweighted Overall, 3 Month Moving Average”. The four measures of wages and total compensation are shown at quarterly frequency in YoY growth rates. The common factor is specified as an autoregressive process of order 4 and it is projected onto the ECI (the measure with the lowest standard deviation). By construction, the absolute level of the estimated common factor cannot be interpreted because the four series are normalized at the beginning of estimation given their different means. Instead, the level of the common factor can be compared to its own history. Latest observation refers to 2022:Q2.