James W. Paulsen, Ph.D.

Perspective

Economic and Market

November 4, 2014

Bringing you national and global economic trends for more than 30 years

A Wage Drama?
Another payroll Friday is just around the corner. The
ongoing drama which is the jobs report has eased
somewhat in recent months mostly because it has
been boringly OK. The unemployment rate has steadily
declined and now at 5.9% is no longer absurdly high,
the volatility in monthly job gains has significantly lessened while averaging an acceptable 220K during the
last year, and finally, wage inflation appears completely
dormant. While the magnitude of monthly job gains
and changes in the unemployment rate will assuredly
remain a central focus each and every month, the drama imbedded in jobs Friday has shifted to wages.
With the financial markets obsessing over how fast
the Federal Reserve may reverse its unprecedented
monetary accommodation, the wage number released
with the monthly jobs report now holds the most
intrigue. Indeed, like any good drama, the titillation
associated with wage inflation has been enhanced since
the Bureau of Labor (BLS) recently changed its primary
benchmark used to measure wages. The current wage
number du jour has only been part of the monthly jobs
report since February 2010. This new wage number
suggests wage pressures remain dormant which has
produced a generalized calm surrounding inflation risk
among both investors and the Federal Reserve. However, the antagonist in this drama, the old wage number,
tells a very different story. This traditional wage number relied on and reported by the BLS for the last 50
years shows wage inflation bottoming about two years
ago and since accelerating by about 1%.
Despite having essentially no history with which to
judge its efficacy, the new wage number is nonetheless
widely considered sacrosanct. It suggests no need to
worry about wages yet and most are indeed nonplussed ignoring the cautionary story being delivered
by a wage number which served as our primary assessment of wage pressures for the last 50 years. Perhaps

the new wage measure is correct and labor cost pressures are not yet showing any signs of emerging. However, should such an important conclusion be based on
a measure which has no history with past economic
cycles? Moreover, should investors simply ignore the
fact that the old wage number (tried and true for a half
a century of economic expansions) suggests wage inflation has already been creeping higher for months? At a
minimum, we think investors should listen and consider
the messages of both measures of wage inflation.
Stay tuned because this Friday another episode is
about to unfold in a drama which is far from over!

A 50-year history of wage inflation

The solid line in Chart 1 illustrates the wage number relied

upon by investors, economists, and policy officials for almost
50 years. It shows the annual percent change in the average
hourly earnings for all non-supervisory workers. This comprises about 80% of all wage earners.
Chart 1: Annual U.S. wage inflation
Non-supervisory workers (solid) versus total (dotted)

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Based on this old tried and true wage indicator, annual wage
inflation bottomed two years ago at 1.3% and subsequently
accelerated to 2.5% in August before falling back to 2.3% last
month. The old measure shows wage inflation beginning to
accelerate in October 2013, a little over four years since the
economic recovery officially began. By comparison, in the
early 1980s recovery, wage inflation did not begin accelerating
until December 1986, a little over four years after the 1982
recovery officially began. Likewise, although wage inflation did
bottom in September 1992, it did not begin to accelerate until
February 1995, almost four years after the 1990s recovery
officially started. Finally, wage inflation did not bottom until
February 2004, two and one-quarter years after the 2000s
recovery started. Dormant or continued deceleration in the
rate of wage inflation long into a recovery has been normal
during the last three decades.
By contrast, the new wage number (the dotted line) has yet
to accelerate in this recovery keeping both the Fed and bond
vigilantes calm. Investors should consider what the Fed would
be doing today and what the 10-year Treasury yield would be
if the old wage number was still widely considered the best
gauge of wage pressures (as it was prior to February 2010).
Wouldnt wage pressures be widely perceived as rising for the
last two years despite rather high unemployment; wouldnt
their acceleration appear normal and on schedule compared
to past recoveries; and finally, wouldnt more expect and fear
wage inflation to soon start accelerating much faster considering the recent significant and unexpected declines in the
unemployment rate?
Currently, there is widespread calm about wage pressures. But
should there be and would there be had the BLS not recently
altered the popular methodology to gauge wage pressures?

The wage dichotomy?

Chart 2 shows the annual rate of wage inflation as reported

by the BLS under the new method of calculation which began
to be reported initially with the February 2010 monthly payroll employment report. Subsequently, the BLS back calculat-

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ed this wage measure to 2007. The two components which

comprise this new measure are illustrated in Charts 3 and 4.
A few observations are noteworthy.
First, as shown in Chart 2, the new method suggests remarkable if not unprecedented stability in wage inflation during
this recovery which is probably why most everyone is so
sanguine about potential wage pressures. Based on this new
calculation, annual wage inflation has been in an incredibly
tight range (of about 0.5%) for the last five years. As shown
in Chart 1, wage inflation has never been this stable for this
long, at least for the last 50 years! Maybe this new measure
of wage inflation is correct, but if it is, wages are behaving in a
manner never experienced in at least half a century.
Second, since 2002, the trend in wages among supervisory
workers (the component added to the old wage number)
could not be more diverse than the trend in wages among
non-supervisory workers. Annual non-supervisory wage
inflation (Chart 4) has accelerated from about 1.3% to about
2.5% while the annual rate of supervisory wage inflation
(Chart 3) has decelerated over the same period from about
3% to about 1%.
Third, supervisory wage inflation tends to be much more volatile than the old measure of non-supervisory wage inflation.
As shown in Chart 3, since this recovery began, its annual
growth rate has declined from 3% at the start of the recovery to about 0.25% by late 2010. Then it rose back above 3%
by early 2013 and subsequently has again declined to about
1%. What drives this component of wage inflation? It appears
random and not closely tied to labor market conditions.
Since 2010, it quickly rose from almost 0% to 3% and then
declined again back to about 1%. Couldnt it quickly and unexpectedly rise yet again toward 3% and, perhaps shockingly,
cause the overall wage number to jump? Essentially, investors
need to consider whether this new wage number could
change much more quickly and unexpectedly than in the past
(perhaps for reasons unrelated to job market tightness or
economic growth).

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Chart 2: Annual wage inflationAll workers

Chart 3: Annual wage inflationSupervisory workers

Approximately 20% of wage earners
Wage inflation for supervisory workers was derived from the
difference between the overall rate of wage inflation less the rate of
wage inflation for non-supervisory workers, based on an 80%-20%
labor mix between non-supervisory and supervisory wage earners.

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Chart 4: Annual wage inflationNon-supervisory workers

Approximately 80% of wage earners

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Summary

Currently, wage pressures are widely perceived as dormant

and the relationship between wage inflation and the unemployment rate is thought to have changed significantly from
historical norms. Primarily, these consensus beliefs emanate
from current BLS estimates which suggest the pace of wage
inflation has been essentially unchanged for an unprecedented five-year period. However, the old measure of wages
suggests the contemporary calm surrounding labor market
pressures may be misplaced. The traditional methodology
shows wage inflation has already been accelerating for about
two years and is behaving very similarly to past recoveries.

Perhaps, as the new BLS measurement implies, wage pressures

are indeed calm and are likely to remain well behaved for the
foreseeable future. However, because the current assessment
of wage inflation differs so significantly from what is implied
by its traditional (and time-tested) measurement, we think the
risk of a surprise to the consensus belief surrounding wages
is elevated. At a minimum, investors should be prepared for a
potential rapid change in consensus thinking surrounding the
labor market and wage pressures. What if the old measurement of wages proves more accurate than the new methodology and wage pressures have already been building for the last
couple years?
In any event, be sure to tune in for the next episode of the
WAGE DRAMA this Friday morning at precisely 7:30 am CT!

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Written by James W. Paulsen, Ph.D. 612.667.5489 | For distribution changes call 415.222.1706 | www.wellscap.com | 2014 Wells Capital Management