The Fed Will be Vindicated on Wage Inflation
The markets have started to price in a slower pace of interest-rate increases by the Federal Reserve even as the labor market strengthens. Many interpret that as a sign investors believe the traditional relationships between jobs, wages and inflation are broken. What it really means is that faster wage inflation will come, only at a lower unemployment rate than in the past.
To understand why, look no further than the internet. It’s widely accepted that comparison shopping is much easier on the internet, and this is almost certainly holding down inflation, as more knowledgeable consumers force companies to be highly price-competitive. The internet has also altered the job search process. Companies can reach vastly more candidates to fill vacancies, which intensifies competition in the labor market.
Before the internet, employers attracted workers by posting job-vacancy signs in their windows or by taking out ads in newspapers. Increases in help-wanted ads were a reliable indicator of a stronger economy. As use of the internet grew, firms found that posting job openings electronically reached a greater number of candidates to fill vacant positions far more effectively and efficiently than newspaper ads. It was no longer necessary for job seekers to subscribe to local papers to find out about openings.
The result was a vast increase in the number of candidates for open positions, greatly increasing the competition between job seekers. When we recently posted two job openings for junior positions on our trading desk, we received hundreds of resumes. Contrast that with 20 years ago when word of mouth might have brought in a handful of candidates, some of whom might have been a poor fit.
Job candidates today understand that they can easily find many opportunities on the internet that align with their interests or skill sets, but they also know that many others will respond to the same postings. On the other hand, employers can fill jobs from a much larger pool of candidates. The net result is a labor market that is far more efficient in matching job seekers with job openings.
The macroeconomic implications of a more efficient labor market are profound. A few decades ago, it was widely believed that unemployment below 5.5 percent to 6 percent was sufficient for labor scarcity to drive up wages. Today the unemployment rate is just 4.4 percent, yet wage inflation pressures have only increased modestly. In technical terms, the Phillips curve has flattened. Our economy can sustain far lower unemployment without sparking faster inflation than in the past. That’s excellent news.
Even so, that doesn’t mean the Phillips curve is irrelevant, or that there’s no relationship between unemployment and wage inflation. For the relationship to cease to exist, it is necessary that declining supplies of labor no longer drive up the price of labor. That’s equivalent to repealing the laws of supply and demand in the labor market. But an improvement in the trade-off between unemployment and wage inflation could always occur if the labor market more efficiently matched up demand with supply. With the internet, it has occurred.
Had the improvement in the workings of the labor market not happened, employers would have a much tougher time filling openings, wage pressures and inflation would be higher, and the Fed would probably have needed to raise rates faster. But with the unemployment rate already down to 4.4 percent, the tightening labor market will eventually elevate wage inflation. Fed policy makers undoubtedly recognize this possibility, which is why it they continue to hike rates, albeit gradually. But they also understand they may run out of runway at any time, so they must remain vigilant.
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