- A new NBER working paper co-authored by economist Larry Summers looks at the current US labour market conditions to predict wage growth.
- It finds that the vacancy rate and quits rate are the best indicators of labour market tightness, and their current levels imply that the unemployment rate should be below 2% instead of 4%.
- Consequently, annual wage growth will likely exceed 6% by 2023, significantly higher than anything the US has seen in the 21st century.
- The cause is the demand for labour combined with the shortfall in employment, which the authors believe is unlikely to change in 2022.
We are experiencing the highest year-on-year increase in the cost of living for 30 years. Unsurprisingly, then, Bank of England Governor Andrew Bailey sparked outrage when he urged workers to avoid asking for big pay rises to compensate. Yet central banks worry rising wage growth could keep inflation higher for longer. Working against them is supply and demand – the number of jobs per jobseeker in the US is nearing two, the highest in half a decade (Chart 1).
With the labour market this tight, what can history tell us about the direction of wages over the next year? A new NBER working paper, co-authored by economist Larry Summers, says US wages will continue to rise. The cause is firms’ demand for workers. Demand-side indicators, such as vacancy and quits rates, indicate a very tight current and future labour market, which has previously led to significant wage inflation.
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Four Measures of Labour Market Tightness
Historically, we have had little need to distinguish between supply- and demand-side measures of labour market slack. Both moved in tandem, meaning different indicators gave broadly corroborative signals of labour market tightness. Since the pandemic, this has changed.
Supply-side (household-side) slack measures such as the prime-age employment ratio and the unemployment rate are elevated, but only at 2016 and 2017 levels, respectively. Meanwhile, demand-side (firm-side) indicators such as the job vacancy rate and quits rate, imply a very tight US labour market (Charts 2 and 3).
So the authors ask, ‘given the divergent signals coming from the labour market, how are we to assess the current degree of slack?’ The key is to examine how well each of the four measures predicts wage inflation. In theory, the tighter the labour market, the higher the wage growth. So the measure that predicts wages the best is the one we should focus on.
Data and Methodology
The authors collect monthly data from 1990 to 2021 on the following:
- Unemployment rate: U-3, from BLS.
- Prime-age employment ratio: Employment-to-population ratio for adults between the ages of 25 and 54, from BLS.
- Vacancy rate: Number of openings divided by the labour force, from BLS JOLTS.
- Quits rate: Nonfarm quits rate, from BLS JOLTS.
- Wages: Average hourly earnings, from BLS.
They then do two things. First, they estimate the effect of the four measures of labour market slack on the YoY growth rate in wages. Second, they use the firm-side labour market indicators (vacancy and quits rate) to create a demand-side measure of the unemployment rate, which they compare with the traditional supply-side unemployment rate (U3).
#1: The Best Predictor of US Wage Growth Is…
For supply-side indicators, the authors find that the unemployment rate provides more useful information about the direction of wages than the prime-age employment ratio. A 1 percentage point drop in the unemployment rate leads to roughly a 0.25% rise in nominal wages.
For demand-side indicators, both the vacancy rate and quits rate are better than the unemployment rate at predicting wage inflation. Of the two indicators, the vacancy rate has the most predictive power.
So, as a crude ranking, the best indicators of future wage growth in the US from worst to best are the prime-age employment ratio, the unemployment rate, the quits rate and then the vacancy rate. And a 1 percentage point rise in the vacancy rate is, on average, associated with around a 0.5% rise in nominal wages.
#2: Creating Two Measures of the Unemployment Rate
Next, the authors create their firm-side measure of the unemployment rate, derived from the vacancy and quits rates. To see whether this is a credible measure, they compare its ability to predict wage growth with the ability of the traditional household measure of the unemployment rate (U3).
The results confirm that both the firm-derived unemployment rate and the household-derived unemployment rate are equally able to predict wage inflation. And so, using unemployment rate predictions from the vacancy and quits rate tells us about labour market slack.
How Will Unemployment Affect Inflation?
The authors then gauge the impact of the current labour market slack on inflation. To do so, they use the vacancy and quits rate to predict where the unemployment rate should be. For December 2021, the firm-side equivalent unemployment rate is between 1.2% and 1.7% – far lower than the actual unemployment rate of 4%.
Given the extremely low firm-side predicted unemployment rate today, these results provide strong evidence that the current labour market is very tight. The firm-side predicted unemployment rate has fallen from an average of 3.6% in the fourth quarter of 2019 to an average of 1.5% in the fourth quarter of 2021. This drop corresponds to an increase in wage inflation from 4.0% to 4.9%.
Regardless of the wage measure (the authors look at four), wage inflation as predicted by the firm-side unemployment rate is now the highest in the 20 years (Chart 4). Also, it is projected to increase dramatically over the next two years, surpassing 6% wage inflation by 2023 with three of the four wage measures.
Why Did Many Workers Disappear During the Pandemic?
How can we square unemployment under 2% with the observation that employment levels remain well below the pre-Covid trend (Chart 5)? The authors cursorily analyse different factors contributing to the employment shortfall and conclude that most are unlikely to reverse rapidly. We outline them below.
- Shifts in Demographic Structure: Population ageing unrelated to the pandemic has decreased labour force participation by around 1.3mn since February 2020. This factor will continue to have a pronounced effect over coming years.
- Covid-19 Health Concerns: Using various data sources, the authors estimate that 1.5mn workers are out of the labour market because of Covid-19. These could be people who are immunocompromised, have long Covid, or have other related health issues caused by the pandemic.
- Immigration Restrictions: Since the pandemic, the working-age foreign-born population has not grown, and immigrants arriving in the US have decreased substantially. This can explain 1.4mn of the employment shortfall.
- Excess Retirements: Retirements spiked at the beginning of the pandemic. Against the normal number of retirees, February 2020 to December 2021 saw an estimated 1.3mn excess retirements.
- Reduced Incentives to Work: Higher benefits, an increase in property values and personal savings, and a change in work-life preferences has increased the reservation wage by 9.3%. Overall, these factors can account for 1mn of the employment shortfall.
- Vaccination Mandates: Around 30% of US workers say their employer has enforced a vaccine mandate. And around 4% of unvaccinated workers have left their job because of the vaccine. In all, this can explain around 0.4mn of the employment gap.
In total, these factors explain 6.9mn of the 7.3mn shortfall in employment relative to the pre-pandemic trend (Chart 6). And the authors believe a substantial portion of the employment shortfall will likely persist throughout 2022. Consequently, they predict that the number of jobs per jobseeker will continue to be extraordinarily high over the next six months, implying significant inflationary pressures from the labour market in 2022.
Was it unfair of the Bank of England governor to discourage UK workers from asking for big pay rises? Based on the evidence from this paper, it may have been. Traditional measures of labour market slack, derived from household supply decisions, suggest workers are not solely to blame for rising wage inflation. It is a combination of labour supply and demand. And, in this instance, the latter appears to be playing a large role.
The firm-implied unemployment rate in the US is less than 2% compared with the 4% household-implied version. This means firms’ demand for workers combined with the shortfall in employment is leading to higher wage growth. Perhaps, then, the factors leading to labour supply shortages should be the main priority, rather than asking the existing workforce to ignore the rising cost of living. Either way, it appears wages will be putting upward pressure on prices in the immediate future.
Sam van de Schootbrugge is a Macro Research Analyst at Macro Hive, currently completing his PhD in international finance. He has a master’s degree in economic research from the University of Cambridge and has worked in research roles for over 3 years in both the public and private sector.
I know that real earnings have fallen, is there a stimulus route the Fed could take that does not contradict their priority of fighting inflation?
and this paper looks only at wage, we have not even considered other shortages