Weak Worker Power to Drive Disinflation

Summary

• I provide a short description (and abundant data evidence) of a strong disinflationary driver largely overlooked by consensus: the weakening of workers’ bargaining power, recently highlighted by two Fed economists.
• Together with tariffs stability and a weak residential market, it gives me conviction that inflation next year is likely to surprise on the downside and that the Fed will cut more than the market is pricing.

Market Implications

• I expect two more Fed cuts in 2025 and three in 2026 against market pricing, almost two more 2025 cuts (43bp), and two-and-a-half 2026 cuts.

Fed Expects Both Lower Inflation and Unemployment

Governor Miran’s policy rate path is lower than the FOMC median and the market (Chart 1). In this note, I discuss how he could be correct, largely due to the consensus overlooking secular disinflation forces.

The Fed’s plan to bring core PCE back to target is basically to keep the unemployment rate above its long-term level for the next three years and allow only for a gradual decline (Chart 2). When set against actual unemployment and core PCE during the five years to the pandemic, this does not appear realistic. The 2015-19 Phillips curve is flat but downward sloping while the SEP 2025-28 Phillips curve is upward sloping!

This reflects the Fed’s inflation model, exposed by then Chair Yellen in a 2015 speech, where she saw the long-term inflation trend driven by long-term inflation expectations (Chart 3 reproduces and updates one of Yellen’s 2015 charts). As long as long-term inflation expectations remain well anchored, the central bank can look through “import prices and idiosyncratic shocks” because inflation will eventually revert to its long-term trend. This time around, with long-term BEs stable, the Fed is hoping that inflation will painlessly move back to target.

Yellen’s inflation views do not seem supported by the data: core PCE is slowing and long-term inflation expectations, measured by long-term BEs, have been stable but this would not have happened had the Fed not hiked 425bp during 2022-23 (Chart 4). So, based on Yellen’s model alone, the Fed’s confidence that inflation will move back to target despite a falling unemployment rate could be misplaced.

Chart 1: Miran’s Dots Well Below Market	Chart 2: Fed Hoping For Painless Disinflation
Chart 3: Pandemic Inflation Not Transitory	Chart 4: Hikes Anchored Long-term Inflation Expectations

Two Fed economists have, however, developed a model of inflation that in my view makes a better job of explaining the past few years’ inflation dynamics. It shows that disinflation with low unemployment is possible but not entirely painless.

Stable Inflation Reflects Weak Workers’ Bargaining Power

The Kalecki-Ratner-Sim model (KRS afterwards; Ratner and Sim developed the model in 2022, based in part on work by Kalecki , a Polish contemporary of Keynes) sees inflation and the slope of the Phillips curve driven by the relative market power of workers and capitalists (i.e. the economic agents who set prices and bargain with workers).

The intuition is that workers’ wage demands are based on expectations of prices and that capitalists in turn set prices based on expectations of wages. When wage and price expectations are inconsistent, inflation rises. Furthermore, the slope of the Phillips curve tends to be steeper when workers have more bargaining power because they are able to extract higher wages when the economy is hit by positive demand shocks, which leads to higher inflation.

The KRS model provides a whole new perspective on the “great moderation”, the period of economic stability between the mid-1980s and the GFC, as well as on the flat Phillips curve that prevailed before the pandemic.

Since the mid-1980s, the market power of the capitalists has increased, as shown by a secular increase in the profit share (Chart 5). This largely reflects the increased concentration of the US economy following the abandonment of antitrust policies. Somehow globalization did not bring about increased domestic competition in the US.

By contrast, workers bargaining power has been weakened by labour saving technological progress, globalization, unfavourable legal and regulatory changes as well as structural changes in the labour market that make it more difficult to organize. This is shown by a decline in industrial action, a widening of the gap between productivity and wages, as well as a secular decline in the income share of wages (Charts 6-8).

Under the KRS model, weaker worker bargaining power leads to disinflation with low unemployment but at the cost of a secular decline in the wage income share, that may not be politically sustainable.

These disinflationary trends are still very much at work.

Workers’ Bargaining Power Remains Weak

Two recent developments show the KRS model is still driving current inflation dynamics. First, contrary to my expectations, the sharp decline in immigration has seen continued wage disinflation. Wage disinflation has continued in Q3 even though the US economy is set for a productivity increase. The Atlanta Fed’s GDP nowcast currently stands at 3.3% QoQ SAAR while consensus for September’s NFP implies employment growth of 0.4% QoQ SAAR. That is, GDP per worker could increase by 2.8% QoQ SAAR. By contrast, based on consensus forecast, real wages are likely to be flat (Chart 9).

This likely reflects workers weak bargaining power. It also implies that the pickup in growth in Q3 is unlikely to be inflationary but instead will support productivity, profits and disinflation.

Second, wage developments during the pandemic are also consistent with the KRS model. Wage growth soared in 2021 as labour shortages (shown by the collapse of the unemployed-to-openings ratio on Chart 10) boosted workers’ bargaining power. With the labour market normalizing, workers bargaining power has weakened and nominal and real wage growth have been slowing.

If my view is correct, we are likely to see continued wage growth below productivity growth, falling wage income share and rising profit share, as well as limited industrial action.

Chart 9: Strong Q3 GDP Supports Disinflation	Chart 10: Weaker Worker Bargaining Power

Market Consequences

In my view the KRS model has not received nearly as much attention as it deserves and the disinflationary dynamics it describes are largely not priced in.

In addition to the KRS model, two short-term developments add to my confidence in disinflation (for detailed discussion of inflation data, see my latest CPI review). First, the stability of the tariffs, that I expect to last at least until the November 2026 US mid-terms, in view of the Trump administration’s low net approval on inflation, -20% (Chart 11). In addition, rising vacancies and slowing market rent inflation add to my confidence that housing disinflation will continue (Chart 12).

Altogether these developments lead me to expect the Fed to be indeed engaged in a cutting cycle, and to cut two more times in 2025 and another three times in 2026.

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