John Lynch Chief Investment Strategist, LPL Financial
U.S. wage growth has been one of the most highly scrutinized economic trends recently. Investors watch average hourly earnings and employment cost data to gauge inflationary pressures, as wages represent up to 70% of business costs, and the Federal Reserve’s (Fed) dual mandate includes achieving stable prices.
So far, wage growth has been contained, but recent reports show wage pressures are rising. The October jobs report showed average hourly earnings grew at a 3.1% pace year over year, the first time annual growth has eclipsed 3% since April 2009. Employment Cost Index (ECI) data for the third quarter confirmed that compensation costs are growing at their fastest pace of the cycle [Figure 1].
While wages are picking up amid a historically tight labor market, we think the current pace of wage growth is sustainable and healthy for the economy, instead of a warning sign of a substantial pick-up in inflation.
We believe data on wages should be viewed in a historical context to understand how the Fed might respond to increasing wage pressures. For this, we use the ECI as a historical indicator of where wages have been during past tightening cycles. ECI growth has averaged 2.4% in the current tightening cycle, far below the 3.3% average rise during the Fed’s last tightening cycle (as shown in Figure 1).
Compensation costs climbed as fast as 3.9% in the year before the Fed first hiked rates in April 2004, significantly above the 2.8% year-over-year increase last quarter. Each of the past five economic recessions started with wage growth around 4%, so wages have room to grow before the pace reaches alarming levels.
The undercurrents of current wage growth paint a picture of evolving domestic and global economies. Wage growth was broad-based across jobs sectors last quarter, as wages accelerated for both private industry and government jobs. Wage costs in service jobs grew the most in a quarter since 2007, boosting year-over-year wage increases to a cycle-high 2.9%, as employers adjusted to the U.S. economy’s shift to a more service-based labor force. Wages in goods-producing jobs grew 2.7% year over year. On an industry level, salary cost increases in sales, office, production, and transportation jobs have led gains, and year-over-year increases for these groups have either met or exceeded cycle highs. On the other hand, wage growth in natural resources jobs, which include construction, farming, extraction, and forestry, has declined for three straight quarters as trade tensions have weighed on the agriculture industry. As the U.S.-China trade dispute continues, wage costs for natural resources jobs may stagnate further as firms seek to reduce expenses to compensate for lost revenue.
The balance of salary and benefit costs could also signal changing dynamics in employee pay as the job market tightens further. In the last several Beige Books, employers noted they were resorting to non-salary benefits over pay increases to attract and retain workers. As wage costs rose at their fastest pace of the cycle last quarter, benefit costs grew at the slowest pace since the second quarter of 2015 [Figure 2].
While benefit costs are heavily influenced by bonuses, slowing growth in benefit costs combined with accelerating salary costs may show companies’ pivot from improving non-salary incentives to increasing pay. We will continue to monitor economic data for shifts in these trends.