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Wage Growth May Signal Inflation Ahead—and Fed Action

Wage Growth May Signal Inflation Ahead—and Fed Action

Photograph by Nick Daly/Getty Images

(An earlier version of this story ran online.)

Barely visible in December’s middling jobs report was a tiny ray of light: Hourly wage increases for a majority of U.S. workers are starting to accelerate after four years of steady decline. In December 2008, hourly earnings for production and nonsupervisory workers were growing at 4 percent a year. Wage growth slid to 1.3 percent by July 2012 and flat-lined for most of the fall. In December it jumped 1.7 percent. That might not sound like much, but it’s the biggest monthly gain since the recovery began.

While workers will benefit from higher wages, the jump in wage growth could spell trouble for the Federal Reserve’s loose monetary policy. Declining wage growth has been the “Fed’s best friend” in its continued argument that it can keep interest rates near zero without triggering inflation, says James Paulsen, chief investment strategist at Wells Capital Management. Wages typically begin to accelerate three to four years into an economic recovery, eventually sparking broader inflation. “If the last 30 years is any guide, this carefree monetary window may be closing much sooner than widely anticipated,” Paulsen wrote to clients in a Jan. 4 note.

The idea of pulling back from loose monetary policy sooner rather than later is gaining adherents among Fed officials. According to minutes of its Dec. 11-12 meeting, “several members” of the Federal Open Market Committee want to slow or stop the central bank’s bond-buying program (known as quantitative easing) before the end of 2013. The bond buying injects cash into commercial banks who can then lend it out.

The call to pull back on quantitative easing comes as a surprise: At the same meeting, Chairman Ben Bernanke won almost unanimous support for a plan to escalate the central bank’s stimulus efforts by purchasing $45 billion a month of Treasuries on top of the $40 billion in mortgage bonds it buys every month. In addition, the Fed pledged to keep interest rates near zero as long as the unemployment rate stays above 6.5 percent and inflation remains in check.

As of December, inflation hadn’t budged. But if wages continue growing and push prices higher while unemployment remains above 6.5 percent, the Fed could find itself torn between its vow to reduce joblessness and its promise to keep inflation low. “We’re really at a crossroads in Fed policy,” says Julia Coronado, chief economist at BNP Paribas (BNP:FP).

The best hope for the Fed is that the economy picks up speed and pulls people back into the workforce. A flood of new job seekers would tamp down wage growth and keep inflation under control. But the recent decline in the unemployment rate owes as much to people dropping out of the labor force as it does to growth and hiring. The smaller the workforce, the fewer jobs needed to reduce unemployment. “That’s not the way they want to get there,” says Coronado. If wages pick up and begin driving inflation higher, yet growth remains tepid, “you might have to concede the economy’s growth potential is permanently lower,” she says. Not exactly what Bernanke wants to hear.

The bottom line: With wage growth starting to accelerate, the Fed may have to raise interest rates more quickly than planned to avoid stoking inflation.

Philips is an associate editor for Bloomberg Businessweek in Washington. Follow him on Twitter @matthewaphilips.

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