Wednesday, August 10, 2016

A relationship between inflation and growth in wages and employment for the US economy

Some folks are speculating that the US economy is approaching full employment. In this post I'm going to explain why I don't believe that is so. I'm going to describe a Phillips curve like relationship between the core rate of inflation, wage growth and job growth. This is something of a work in progress. It seems to work well for the US economy, and a very similar approach appears to work for the UK, but I have not applied it to other economies yet.

On the y-axis I will plot the percentage growth in the product of wages and employment. For example, for January 1965 wage growth is 3.2% and employment growth is 3.6%. The quantity (wages*employment) grows by a 7% and this I plot on the y-axis.

The US economy seems to take time to respond to changes in employment and wages. On the  x-axis I will plot core inflation delayed by 21 months. For example, for the January 1965 data point I use the inflation from October 1966.

The best fit line shown on the chart predicts 2.2% inflation in October 2017 based on current rates of wage and job growth.  The growth in (wages*employment) is currently 4.4%, and it has never gone above 7% since 1992. In that time inflation has stayed under 3%.

Under what circumstances should we be concerned about a return of inflation? When inflation took off in the late 1960s the  growth of (wages*employment) was a little over 8%. From 1972 until 1981 it never fell below 7%. As long as it stays under 7%, inflation should stay low.

With growth in (wages*employment) at 4.4% as of January 2016, there is clearly a lot of room for stimulating the economy. When we approach full employment, wage growth should rise substantially.

 Notes and data sources

1/ All data is from FRED. For wages I am using the  "Average hourly earnings of production and non-supervisory employees: Total Private (AHETPI) " The data is seasonally adjusted. For January of each year I take the percent change from the previous year.

2/ For employment I am using "All employees : total nonfarm payrolls (PAYEMS)" seasonally adjusted. For January of each year I take the percentage change from the previous year.

3/ For core inflation I am using "Consumer Price Index for All Urban Consumers: All Items Less Food and Energy (CPILFESL)" I take the annual rate of change delayed by 21 months. For example, (earnings growth * employment growth) for January 1965 is plotted against inflation for October 1966.

4/ Care needs to be taken with the arithmetic. For example, wage growth of 3.2% is a factor of 1.032. Employment growth of 3.6% is a factor of 1.036. Earnings growth * employment growth = 1.032*1.036 = 1.069 which is equivalent to 6.9%.

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