The Missing Wage Inflation / Unemployment Paradox

Why central banks are finding the outlook for monetary policy so difficult

The Phillips Curve describes the inverse relationship between unemployment and inflation: as unemployment falls, inflation (specifically wage inflation) rises due to a lower supply of workers. While this is a simplistic understanding of what drives inflation, the relationship is instructive in understanding the current cycle, and why the Fed [1] has found the post-Crisis period so difficult to navigate.

The chart below looks at unemployment (x-axis) versus wage inflation (y-axis), breaking the data down into different time periods and including data back to 1967.

Source: Waverton; Factset. Data to 09.07.17

The post-Financial Crisis period (2008-2017) is depicted in dark grey squares, and a few things are immediately apparent from charting the data.

First, 2008-2017 is the only period with sustained negative wage inflation. Second, despite being 9 years into the recovery (and notwithstanding globally loose monetary policy for most of the period), wage inflation remains well below historic averages for a 4.3% unemployment rate.[2] Third, the relationship is shallower than in the past; if we ex-out negative wage inflation then for every 1% fall in unemployment, wages rise just 0.32%. In the 2000-2007 period this ratio was 1:2.5, and 1:1.1 in the 1990s.

The above is necessarily backward-looking, and we would caution against extrapolating the results into the future. Indeed, as the unemployment rate continues to fall, the probability of a substantial rise in wage inflation rises.[3] However, the analysis is instructive insofar as monetary policy decisions are concerned: persistently low inflation notwithstanding historically low unemployment rates makes central bank decisions both extremely difficult and of utmost importance (which explains the market’s obsession with central bankers and their speeches).

There are structural reasons for low inflation as we stand today: global trade and the introduction of China into the WTO, technological advancement, increasing efficacy and importance of monetary policy, amongst others. However, there are also cyclical reasons for higher inflation. Because bond yields remain near historic lows, the risk of higher inflation (leading to higher yields and thus lower bond values) is significant. We remain cautious in our outlook for fixed-income assets, and only hold duration as a portfolio hedge (not as a likely source of return).

By  James Mee

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[1] Federal Reserve; the United States’ central bank

[2] In fact, the latest wage inflation print (2.95%) is the lowest at 4.3% unemployment since 1967

[3] The relationship becomes increasingly non-linear, so a 1% fall in unemployment results in an increasingly large change in wage inflation