According to the BLS, in December the unemployment rate declined to 3.9% and average hourly earnings (AHE) for all employees on private nonfarm payrolls increased 4.7 YoY.
According to the Fed staff (2021) Taylor rule, the BLS report implies 4 hikes in 2022 (the first one of which in Q1 (March)). Please, find below the updated Taylor rule together with some comments about recent developments of nominal wage growth.
To keep in mind
Conditions for lift-off appear to have met on both sides of the mandate. The Fed staff (2021) Taylor rule (assuming that the unemployment rate will average 4 percent or less in Q1) now implies 4 hikes in 2022 starting in March.
Wages are rising at a robust pace in aggregate. Nominal wages at the bottom of the distribution are rising at double digits. The literature suggests when gains are concentrated on the lower part of the distribution, nominal wages can, in fact, put upper pressure on consumers prices.
The revised path of the FF rates
Given that the unemployment rate is now below the (SEP) natural rate, we have updated the path of the FF rates implied by the Fed staff (2021) Taylor rule.
Reminder: the Fed staff (2021) rule is an inertial Taylor rule that is meant to capture the behavior of the FF rates post strategy review. The key ingredients are the following: (i) it is highly inertial (autoregressive coefficient is 0.94), (ii) it assumes that the FF rates are constrained at zero until two conditions are met: the unemployment rate falls below U*, and core PCE price inflation is above 2 percent. Conditional on the SEP forecasts, the Fed staff (2021) Taylor rule has fitted the median of the dots plot perfectly since its introduction.
Conditions for lift-off have now been met: the unemployment rate is below the natural rate and core PCE price inflation is above 2 percent.
For this reason, we have updated the predicted path of the federal funds rates using the latest SEP forecasts but assuming that the unemployment rate will average at (or below) U* in Q1. The figure below shows our results.
The new path of the FF rates implies lift-off in March and 4 hikes in 2022. The level of the FF rates in 2024 is very similar to the median of the dots plot because the forecast for the unemployment rate and the inflation rate at the end of the medium-term is unchanged.
The behavior of wages
Wages are rising fast. Average Hourly Earnings (AHE) expanded 7.6% MoM at a.r. in December. Even more importantly, AHE in “Leisure and Hospitality” grew at 10.4% MoM at a.r. This evidence is important in two dimensions:
- In 2020 the level of the AHE was (upwardly) biased by composition effects (lower paid workers were disproportionally affected by the pandemic). In 2021 the assumption was that by re-joining the labor market, lower income workers would have biased downward the level (and the growth rate) of the AHE. Instead, we have witnessed large nominal gains, concentrated at the bottom of the income distribution.
- In recent months, a growing evidence has shown that if wage inflation is concentrated at the bottom of the income distribution it tends to be more inflationary. You can see these papers: “Wages, Minimum Wages, and Price Pass-Through: The Case of McDonald’s Restaurants”, “The Pass-Through of Minimum Wages into US Retail Prices: Evidence from Supermarket Scanner Data”, “Minimum Wage and Real Wage Inequality: Evidence from Pass-Through to Retail Prices”.
Implications for the Fed staff. The Fed staff tends to monitor quarterly measures of wages and salaries (in particular the Employment Cost Index (ECI), and the Compensation Per Hour measure). Nevertheless, the staff also monitors (and forecasts) the AHE because the wage component of the ECI is based on the AHE (for this reason, please expect a robust ECI growth in Q4). The staff view of the passthrough of labor costs to price inflation is esemplifed by Peneva and Rudd (in a nuthsell: according to Peneva and Rudd it is hard to see any passthrough in the data). However, the recent evidence of the literature combined with the incoming data represents a risk for the staff. At this point, with nominal wages rising so fast at the bottom of the distribution we think it cannot be ruled out that the wage dynamic will put some upward pressure on consumers prices going forward. As such, this represents a big upward risk for the staff forecast.
Based on the above, we reiterate that in our view the chances for liftoff in March are now extremely elevated (90% at least).