Justin Wolfers wrote a very good article in the New York Times on the so called relationship between wage growth and the level of unemployment. Recent unemployment data from the USA has shown that it has fallen faster that what was anticipated – figures have fallen 1% in the past three years to 5.9%. However what is unusual about this is that the economics textbooks say that lower unemployment leads to faster wage growth and this has not been evident – see graph below. Wages tend to increase when:
1. Workers feel they have job security
2. When there is lower unemployment companies feel they need to pay better wages to attract the best workers
Ultimately when there is wage growth these extra cost pressures feed through into higher inflation something that has not been prevalent in the US economy. The key variable in this situation is how much spare capacity is in the labour market. When unemployment gets near to its natural rate this puts pressure on prices. Any central bank would be very cautious to further stimulate growth when unemployment is close to the natural rate of unemployment – NRU. The issue is that the Federal Reserve are not entirely convinced that they know what the NRU is – their current estimate is 5.5%. How can we explain that the lack of wage pressure is evident when the economy is about to run out of spare capacity? There are a couple of explanations:
1. The unemployment rate is giving us a false signal, and there are millions more workers waiting to return to the labour market than suggested by the official statistics. That is, the jobless will return when the jobs return.
2. The natural rate is really much lower than most economists estimate. After all, at the end of the Clinton administration, unemployment was below 4 percent, while inflation remained low and stable.
Business will only feel it necessary to increase prices if wage growth is greater than inflation and the rate of productivity growth. With the Fed Reserve targeting inflation of 2% and productivity growth at approximately 1-2% the economy is out of spare capacity when wage growth is between 3-4%. This suggest that there is currently spare capacity.