What is the Wage - Inflation Relationship Telling Us?

There are many employment statistics that play second fiddle to the headline U-3 data but two of them, the employment cost index and average hourly earnings, affect every American that still has a job.  

Let's start by looking at the employment cost index (ECI).  This statistic measures the cost of workers' wages and salaries as well as benefits and bonuses at all levels in Corporate America.  The Bureau of Labor Statistics bases the ECI on a survey of employer payrolls in the final month of each quarter.  The ECI is considered a leading indicator of inflation since compensation generally increases prior to companies increasing prices for its goods and services.

Here is a graph from FRED showing the employment cost index since 2001:

While it might appear to be a steady increase, such is not the case.  Here is the same data showing the percentage change from the previous year:

Since the end of the Great Recession, it is quite apparent that growth in the employment cost index has been very low, ranging from 1.4 percent in Q3 2009 to 2.3 percent in Q4 2014 and has grown at an average rate of 1.83 percent over the five year period.  This compares to an average increase of 3.0 percent annually over the period from Q1 2002 to Q1 2008.  While there has been upward pressure in employee costs over the last two quarters of 2014, the data would suggest that there is very little upward pressure on inflation related to increases in compensation.

Now, let's look at average hourly earnings.  Here is a graph from FRED showing average hourly earnings of all employees in the private sector since  early 2006:

Once again, while it may appear to be a slow and steady increase, the same data showing the percent change from the previous year would suggest otherwise:

In December 2014, average hourly earnings had increased from the previous year by only 1.65 percent.  Since the end of the Great Recession, on a year-over-year basis, average hourly earnings have increased by an average of 2.0 percent.  While the data prior to the Great Recession is not complete, on a year-over-year basis, average hourly earnings increased by an average of 3.4 percent.  

To get a better sense of pre-Great Recession earnings growth, while it doesn't cover all non-farm occupations, we have a more complete database when we look at year-over-year increases in average hourly earnings of production and non-supervisory employees as shown here:

It is quite apparent that the Great Recession had a significant impact on wage growth.  During the years between the 1990 - 1991 and 2001 recessions, the average wage grew by 3.3 percent on a year-over-year basis.  During the years between the 2001 and 2008 recessions, the average wage grew by 3.1 percent on a year-over-year basis.  This is substantially more than the 2.0 percent average annual increase since the end of the Great Recession.

The Federal Reserve is obviously watching wage growth since increased wages foretell inflationary pressures.  Back in December 2006 when Alan Greenspan was her boss, Janet Yellen expressed concerns that increasing employee compensation could have put increasing upward pressure on inflation as shown in this comment:

"On the one hand, recent labor market data point to a lower path for the unemployment rate than before, and all else being equal, this boosts our inflation forecast a bit. Offsetting this effect, on the other hand, is the huge downward revision in compensation per hour. When these data came out, I let out a big sigh of relief. The revised data are more consistent with the indications we were getting from the employment cost index and suggest that wage growth has remained contained."

Ms. Yellen made it quite clear that her priority was to control inflation and that she was quite pleased to see a downward revision in employee hourly compensation.  From both the employment cost index and the average hourly earnings data, it looks like Ms. Yellen and her merry band of central bankers will be able to sleep comfortably at night, knowing that the modest increases in compensation for America's workers will put little upward pressure on inflation.  That's one less thing that she needs to worry about when contemplating when she should push interest rates up.