The US unemployment rate continued its inexorable decline in April reaching 3.9%, its lowest level in 18 years. But at the same time, wage growth is moving only gradually higher. The upshot is that while the target Fed funds rate is below the estimated neutral rate, the Federal Open Market Committee (FOMC) will continue to hike interest rates with the next increase in June.
One of the great conundrums of the post-Global Financial Crisis world is that the US unemployment rate has lost its potency in predicting wage and inflation outcomes. Many reasons have been advanced for that, with the most compelling being the decline in the participation rate and the still elevated levels of broader measures of labour market slack.
But even those measures are now at historically low or ‘tight’ levels. The ‘U6’ measure of US unemployment (which includes discouraged workers, others who are marginally attached to the labour market and those who are part-time for economic reasons) is at 7.8% in April, its lowest level since early 2001.
So the labour market is undeniably tightening but this is yet to have a meaningful impact on wage growth and inflation. Wage growth is trending higher, but progress remains painfully slow. Average hourly earnings (AHE) had a brief spike higher earlier in the year, but has since settled back to rising at an annual clip of 2.6%. The Employment Cost Index had its own spike higher in the March quarter, but this was simply this measure of compensation playing catch-up with AHE.
Another dynamic playing out after a long period of disappointment is improved labour productivity. March quarter data had the annual rate of increase running a 1.3%, still low by historical standards but an improvement on the performance of the last couple of years.
Remember productivity is our “indicator to watch” in 2018 after we watched business investment closely in 2017. Productivity holds the answer to a number of questions this year, including how long the economy can extend its above trend growth performance, but also the trajectory of wage growth as productivity typically leads employee compensation.
We expect labour productivity to remain strong this year as payrolls growth slows in a tight labour market and business investment remains solid. Wage growth can be expected to accelerate as the labour market continues to tighten and productivity improves. At the same time, the improving productivity makes those wage increases more affordable for firms by keeping unit labour cost increases in check.
The upshot of all of this is the FOMC will have confidence to deliver on their forward guidance. Expect the next hike in June, an eventual move up in the ‘dots’ to a total of four hikes this year and further increases in 2019. This will underpin the continued trend increase in global interest rates and keep returns of bond portfolios low.
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