Wage Growth Is the New Inflation Rate

First it was the unemployment rate. Then it was inflation. Now workers’ hourly wages could be the key economic indicator that will determine when and how the Federal Reserve will eventually raise interest rates.

When wages start to rise such that consumers increase their spending, it will help drive up demand for goods, which in turn will lift prices toward the Fed’s target rate goal of 2%. When that happens, the central bank will start gradually lifting short-term interest rates from the near-zero range where they’ve sat for nearly six years.

But, as Janet Yellen and other influential Fed officials have vowed time and again in recent months, it won't happen before then.

Indeed, Yellen and her colleagues have said interest rates won’t start moving higher until the central banks achieves its dual mandate of full employment and price stability, which the Fed has defined respectively as an unemployment rate in the range of 5.2%-5.6% and inflation at a range of 1.7%-2%.

As the Fed has begun the transition back toward a policy of “normalcy” after years of unprecedented stimulus in the wake of the 2008 financial crisis, central bank policy makers have already cycled through two of the most historically important economic indicators – the unemployment rate and inflation – as barometers for the health of the economy.

Two Percent Inflation Goal Has Proven Elusive

Former Fed Chair Ben Bernanke famously suggested in June of 2013 that the Fed could begin raising interest rates when the unemployment rate fell to 6.5%. Then the unemployment rate unexpectedly started to drop, from 7.5% at the time Bernanke made his comment to its current six-year low of 5.8%.

But Fed economists were quick to note the headline unemployment rate hardly told the whole story of the health of U.S. labor markets. Consequently, the Fed backed away from Bernanke’s 6.5% threshold and established the new range focused on the Fed’s dual mandate, which also includes the inflation target.

While that 2% inflation goal remains in place, it has become increasingly elusive. That’s why workers’ average hourly wages has emerged as the latest economic indicator scrutinized by the Fed to determine when to raise interest rates.

Wages have been stagnant for months even as the unemployment rate has tumbled. According to figures released by the Labor Department last week, average hourly earnings for all employees on private nonfarm payrolls rose by three cents to $24.57 in October. Over the past year, average hourly earnings have risen by just 2%, or well below the 3%-3.5% rate the Fed views as necessary to raise inflation to that desired 2% target rate.

So what’s keeping wages stagnant despite the sharp decline in the unemployment rate, and a healing economy that’s creating on average more than 220,000 jobs each month over the past year?

“There’s still a large amount of slack in labor markets, more than the unemployment rate alone would suggest,” Gus Faucher, senior economist at PNC Financial Services Group explained.

It’s that “slack” that’s keeping wages low because as long as it's there, it creates a surplus of workers, which means employers have no reason to raise wages in order to keep or attract employees.

Reserve Pool of Workers Keeping Wages Low  

That slack has resulted from, among other reasons, thousands of Americans who are stuck in part-time jobs but who would rather be working full-time, college graduates desperate for work who have taken jobs normally filled by high school grads, and retirees (many of them on pensions) taking jobs that might otherwise be given to mid-career workers who would command higher salaries.

“As long as there is still this reserve pool of workers out there employers won’t see the need to raise their wages,” Faucher said.

But he pointed to the average monthly gains of more than 200,000 jobs each month as a sign of “progress” toward tightening that labor market slack, which would ultimately lift wages. He said he sees wages starting to rise more significantly in 2015 and expects the Fed will respond by lifting interest rates likely in July.

When rates do move higher it will make borrowing money more expensive, which will raise the costs for consumers for most big-ticket items purchased with loans,including homes and cars. In addition, it will make it more expensive for small businesses to borrow to expand.

For those reasons, the Fed has pledged to be cautious and patient as it ponders a timetable for raising rates. And once liftoff is announced the Fed is certain to raise rates gradually to give markets and consumers time to adjust to the return to “normalcy.”

“Workers haven’t shared as much in the recovery,” Faucher said. “And the Fed would like to see rates stay near zero until we see wage growth accelerate.”