It changes nothing
Wage growth is still well above the level consistent with the Fed target. After today’s ECI report, the broad picture remains the same: compensation growth is projected to remain above structural productivity and underlying inflation throughout the medium-term, although a bit less than before.
The incoming data
According to the BLS, over the three months ending in December, total compensation for private industry workers increased 4.0% QoQ (a.r.) and 5.1 percent YoY. Wages and salaries increased 5.1 percent for the 12-month period ending in December 2022, while the cost of benefits increased 4.8 percent.
Our model-based forecast
The inclusion of the fourth quarter in the sample resulted in a downward revision of the model forecast (2 tenths lower at the end of the medium-term) as the incoming data were a bit softer than the model expected. The YoY of ECI total compensation for private industry workers is now projected at 3.9 percent in 2023, 3.3 percent in 2024, and 3.0 percent in 2025 (see Figure 1). Compared to the previous forecast, the current forecast is about 2-3 tenths lower throughout the forecast horizon. Having said so, even with today’s downward revision the model forecast remains above the level (3%-ish) consistent with the Fed target in most of the forecast horizon.
(For the record: we have run the model using other measures of “slack” and we got similar results. For instance, under the assumption that V/U returns to 1.0 in 2024:Q1, the model delivers a YoY forecast of 3.1% at the end of 2025)
Figure 1. Phillips curve model-based ECI forecast
Current forecast, model-based
Comparison: current vs. previous forecast (QoQ and YoY)
Note: the figure shows the ECI Phillips curve model-based forecast (YoY). The charts refers to the year-over-year percent changes of compensation costs for private industry workers. The confidence intervals are based on the estimated parameters distributions. The table on the right shows a comparison between the current forecast (2022:Q4 last quarter in-sample) and the previous forecast (stopping the sample in 2022:Q3).
The Fed staff forecast
The Fed staff forecast is (finally) in line with the estimated model and there is little residual in the judgmental decomposition in 2023. Below we show the ECI forecast that, in our view, the Fed staff has written in the January 2023 Tealbook and the decomposition (contributions) the staff has discussed with Powell and the Governors (slide #41 from our Pre-January 2023 FOMC Meeting Package).
Figure 2. The ECI compensation Fed staff judgmental forecast and its contributions
Note: the figure shows our view of what the Fed staff has written in the January 2023 Tealbook for ECI (total compensation, private industry workers) growth. The black line shows the YoY percent change of ECI growth. “Other factors” refers to factors that cannot be otherwise attributed. “Slack” refers to the contribution of the unemployment gap. “Structural productivity” refers to the trend of labor productivity (output per hour, non-farm business sector) growth.
In our view and experience, according to the Fed staff ECI decomposition, the contribution of underlying (business sector) inflation should remain above 2 percent in 2023-2025. Structural productivity is expected to add about 1 percent per year in the medium-term. Slack (as captured by the contribution of the unemployment gap) is expected to add about 30bps this year but gradually fade as the unemployment rate converges back to the natural rate in 2025. Crucially, the “other factors” (that is, the quasi-residual of the decomposition) are expected to be small in 2023 after two years (2021 and 2022) in which they were large and positive. (please, note that if slack was captured with V/U instead of the Ugap, than the yellow bar in 2021 and 2022 would be much smaller in favor of a bigger red bar. The same would happen in 2023). In other words, after missing wage growth on the upside for quite a long time, the Fed staff seems finally on track.
How much upper pressure on core (PCE) prices should we expect from wage growth going forward?
The evidence suggests 30-40bps upper pressure on core inflation going forward from wage growth. The answer to this question can be found in Peneva and Rudd (2015). Figure 2 of the paper (see page 26 of the paper) shows the response of core PCE price inflation to an innovation in ECI compensation. According to the estimates of Peneva and Rudd, a 1 percent shock of ECI growth results in about 15-20bps on core PCE price inflation. Therefore, because ECI growth is currently about 2 percentage points higher than the estimated fundamentals, it is reasonable to expect about 30-40bps upper pressure on core inflation going forward from this margin.
Conclusion
Today’s ECI report changes nothing for the Fed. Our analysis shows that compensation growth continues to be expected above structural productivity and underlying inflation throughout the entire medium-term (2023-2025). Assuming a higher pi* alleviates the tension in the forecast but results in a price (PCE) inflation forecast significantly above the Fed staff (and the FOMC) in the medium-term. As such, in our view and estimates today’s ECI report changes nothing for the FOMC.