There are many things to fear when looking at the economy and its capacity for surprising, and wages taking wing may be one of them. Of course, if you’re a long-suffering worker, the trend is worthy of celebration. But expecting the pace of labor income to keep running higher is something to lose sleep over if you’re a central banker (or an investor betting that rates will stay flat or fall).
Indeed, the subject or wages promises to be the new new thing as 2006 goes into its final stretch. To be precise, how much of the bubbly wage growth of late will be inflationary? Or, to summarize the optimists, will the upward trend in wage growth be offset by productivity gains and weakness elsewhere in the economy, notably in real estate? Such are the questions that keep investors wondering and economists working.
Analysts Charles Dumas and Gabriel Stein of Lombard Street Research in London believe that the folks at the Fed may lose a little shut-eye in the foreseeable future. Stein wrote yesterday in a note to clients that “labor income growth is accelerating” in the U.S. His colleague, meanwhile, observed last week that “huge” revisions on wage growth estimates point to more Fed tightening.
Not everyone agrees, of course, and we’ll get to that shortly. But first, a closer look at Lombard’s analysis, starting with Stein. The U.S. economy is entering what he calls an anti-Goldilocks phase, which he defined as “both too hot and too cold at the same time….” Too hot, he continued, “in the sense that household incomes clearly remain strong and are likely to keep powering the economy for some quarters further. In fact,

with non-farm labor income rising by 6%, household spending by itself should be enough to propel the economy to close to trend rate growth–always assuming, of course, that the savings rate does not suddenly begin to rise.”

If history is a guide, the latter seems unlikely, at least any time soon. Joe Sixpack has been conspicuously profligate for years when it comes to spending, which suggests that the prospect of rising incomes will further fuel his fondness for running down to the mall and pick up another TV or two.
In any case, Stein added that while household incomes have been bubbling, the housing market has been cooling. The combination of hot and cold will “bedevil the Fed” on through 2007, he predicted. Ultimately, however, another increase in the Fed funds rate will come, he predicted.
Meanwhile, Dumas has been watching the revisions to hourly pay estimates and found that the bias has been upward in more than a trivial way. The trend, he concluded, has diminished the chances for a “serious” economic slowdown for the foreseeable future. As such, he too predicted that the Fed will be “forced into tightening.”
But Ed Yardeni begs to differ. The chief investment strategist for Oak Associates is a bull, and makes no apologies. He wrote in an email to clients this morning that rising productivity will help save the day by keeping a lid on any inflationary pressure born of increased spending by way of rising incomes. Meanwhile, the second-quarter’s 7.7% annual jump in nonfarm business hourly compensation (the biggest since 2000) “is mostly attributable to profit-sharing,” he counseled, effectively dismissing its powers to elevate inflation by any magnitude.
Nonetheless, observers should take note that even Yardeni agrees that incomes aren’t flat, as some pundits assert. “Despite all the nonsense that American workers’ incomes have stagnated for the past five years,” he wrote, “inflation-adjusted hourly compensation for both the [non-farm business] and [nonfinancial corporate] sectors were at record highs during Q2, up 10.6% since the start of the decade and up 24.0% since Q3 1995!”
The debate, then, is not over whether incomes are rising at a healthy clip these days. Rather, the question is what will the trend do, if anything, to offset the slump in real estate, which is said by some to be the catalyst for a slowdown or even recession in coming quarters? Also, while we’re asking questions, what effect will rising incomes have on inflation going forward? Yardeni, Stein and Dumas have a view. The great unknown how the Fed will react.
As for Mr. Market, he’s staying calm for the moment when it comes to looking ahead for monetary policy. October Fed funds futures could hardly be less volatile these days. The contract continues to be priced in anticipation that next week’s FOMC meeting will keep Fed funds at 5.25%. The pause, in short, is still thought to have legs.