Encouraging as the U.S. job market may be, its strong recovery presents a challenge for the Federal Reserve: If companies start paying workers more, at what point should the Fed begin increasing interest rates to guard against inflation?
So far, the evidence suggests the Fed is right to be patient.
Employers turned in another impressive performance in February, adding an estimated 295,000 jobs across a broad range of nonfarm sectors. The increase brought the three-month average job gain to 288,000, more than enough to lower the unemployment rate, which declined to 5.5 percent from 5.7 percent in January.
The demand for workers, though, isn't yet having a broad effect on pay. Wal-Mart has promised raises starting in April, and the Fed has noted signs of wage pressure in some U.S. regions. But average hourly earnings in the private sector rose just 3 cents in February to an estimated $24.78. That's up 2 percent from a year earlier, far short of the pace that prevailed before the recession.
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Wage growth plays a crucial role in Fed officials' assessment of how much they should do to support the economy. On one hand, they would like to see people getting paid more -- otherwise consumers won't have enough spending power to support a healthy recovery. On the other, rising pay could put upward pressure on prices, which could trigger an inflationary spiral that the Fed would have a hard time getting under control.
So how much do wages need to grow before the Fed has to worry? Given the raw deal workers have gotten so far in this recovery, it could be a lot.
Consider, for example, the gap between pay and productivity. On average in previous economic expansions, more than half of any increase in employees' output per hour has come back to them in the form of higher compensation, with the rest going to corporate profits. This time around, hourly compensation, adjusted for inflation, has risen at an annualized rate of only 0.1 percent, compared with a 1.2 percent annualized increase in productivity. Here's how that looks:
The unusually low share of productivity gains going to workers is one reason Fed Chair Janet Yellen has suggested that she wouldn't immediately be too concerned about inflation if pay started to rise. To be sure, there's no guarantee workers will regain their historical share. Maybe people are being replaced by robots and other technology, or maybe increased global competition has eroded bargaining power. Even so, just getting halfway back to the traditional balance between pay and productivity would require a significant raise: Wage growth would have to outpace inflation by more than two percentage points for a year.
All told, the Fed has ample reason to believe that the U.S. economy can make much more progress toward improving the lot of millions of workers -- and the millions who still lack jobs -- before inflation becomes a threat. It should stick with that conviction until the facts prove otherwise.
-- Bloomberg View