Global Macro Strategy

A weekly analysis of timely economic strategy issues from Wells Fargo Investment Institute.

March 28, 2017

Craig P. Holke, Investment Strategy Analyst
Paul Christopher, CFA, Head Global Market Strategist

The Relationship between Wages and Inflation

  • Wage growth has shown recent signs of acceleration. Do higher wages lead to higher inflation down the road? Research shows that the relationship is the opposite: higher inflation leads to higher wages.
  • The Federal Reserve (Fed) is currently measuring inflation expectations as low. If inflation matches these expectations, inflation should not act as a trigger that causes wages to rise at an accelerated rate.

What it may mean for investors

  • Moderate inflation and solid, but not overly accelerating, wage growth should be a net positive for the U.S. economy. Higher wages should lead to increased spending or savings, without causing deterioration in corporate profits.

Wage growth has begun to show signs of acceleration following the sharp decline experienced during the last recession. Higher wages benefit workers and allow them to either increase their spending or savings. Increased wage growth also can be a negative for businesses. Businesses are faced with either allowing the increased cost of labor to reduce profits or attempting to raise prices.

Chart 1: Year-over-year Measures of Wage GrowthChart 1: Year-over-year Measures of Wage GrowthSources: Bureau of Labor Statistics, Federal Reserve of Atlanta, Bloomberg, Wells Fargo Investment Institute; March 27, 2017. Year-over-year, percent change.

Wage growth can be tracked by a number of measures, including the Bureau of Labor Statistics’ average hourly earnings and the Atlanta Fed’s Wage Growth Tracker. Each of these methods is slightly different, but the trend has been a pickup in wage growth, as Chart 1 shows. While wages have been rising, they are not currently near levels experienced at the beginning of recent recessions.

With labor costs representing a large portion of a firm’s total costs, it was originally thought that higher wages drove overall price increases. Research from the Federal Reserve Bank of Cleveland shows that it is more often the case that wages rise in response to inflation (and are not a cause).1 It is the expectation of higher inflation in the future that drives wages. In general, if employees are expecting their cost of living to rise in the future, they will negotiate for higher wages today. Employers may lack the ability to raise prices purely because of higher wages. If the market will not tolerate the higher prices due to competition, higher wages will simply reduce corporate profits. On the other hand, if strong demand allows firms to raise their prices, then workers could demand a larger portion of the profits in future wage negotiations. Wages also have decreased as a percent of total compensation received by workers due to rising insurance and other benefit costs.

Productivity also plays a significant role. Greater productivity leads to a reduction in per-unit costs that, in turn, increases corporate profits. This allows more room for labor to gain a greater share of the increased corporate profits (without raising the overall level of prices). Thus, if labor productivity is strong, wages can rise without driving overall inflation higher. The increase in output offsets the effect of higher wages.

Chart 2: Current Market-based and Surveyed Inflation Expectations (Percent)Chart 2: Current Market-based and Surveyed Inflation Expectations (Percent)Sources: Federal Reserve, Federal Reserve Bank of Philadelphia, Bloomberg, Wells Fargo Investment Institute, March 27, 2017. Annualized percent; quarterly data. The Fed Five-Year Forward Breakeven Inflation Rate is a market-based measure of inflation expectations derived from the Treasury Inflation-Protected Securities’ yield curve compared to the corresponding nominal Treasury yield curve. The Survey of Professional Forecasters’ Five-year CPI Inflation Rate is based on a survey conducted by the Philadelphia Fed asking professional economic forecasters for their view of inflation in five years.

Today, expectations for future inflation remain at levels that do not cause concern. Chart 2 shows two measures for inflation expectations. Both the Fed’s Five-Year Forward Breakeven Inflation Rate, a market measure, and the Philadelphia Fed’s Survey of Professional Forecasters’ Five-Year Consumer Price Inflation (CPI) Rate show that inflation expectations have been declining until recently and remain close to two percent over the next five years. Inflation expectations at these levels do not provide a reason for wages to significantly increase over the near term.

Investment Implications

The result is that, for the time being, higher wages may be a net positive for the domestic economy. Workers have more income with which to either increase their spending or savings. If wage growth begins accelerating, it does pose the risk of eating into corporate profits and causing a reduction in business investment and hiring. These factors (frequently seen prior to a downturn in the economy) are not present to the degree that would raise our concern about a recession this year. Domestic equities respond well to moderate inflation, and we believe that the potential for increased spending from higher wages will continue to drive economic growth. Bonds are sensitive to inflation, and the inflation expectations currently seen at roughly two percent should not be a cause for concern.

Moreover, we believe that opportunities in equity markets should come mostly from those sectors most closely tied to economic growth—namely, the Consumer Discretionary, Industrial, and Financial sectors. We also recommend overweighting Health Care at this time. In fixed income, we recommend holding exposure above long-term target allocations in intermediate-term, investment grade bonds.

1 Federal Reserve Bank of Cleveland, “Does Wage Inflation Cause Price Inflation”, Gregory D. Hess and Mark E. Schweitzer, April 2000.

Risk Factors

All investing involves risks including the possible loss of principal. Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities.

Investments in fixed-income securities are subject to market, interest rate, credit/default, liquidity, inflation and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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