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Economic Comment

Our Weekly Economic Report

July 23, 2008

Wage Inflation Moderates

Wage inflation as measured by the growth in average hourly earnings peaked at 4.28% in the 12 months ended in Dec. 2006. Since that time, wage inflation has slowed to only 3.45% in the year ended in Jun. 2008. The recent decline in wage inflation is typical for a weak economy. When the unemployment rate is increasing, workers worry more about job security and less about wage increases. Consequently, wages tend to rise at a slower pace.

Falling home values also reduce the risk of commodity inflation spreading to other areas. When consumers are worried about declining housing values and job security at the same time, they may not be willing or able to pay more for other non-essential goods and services. Therefore, it is more difficult for companies to push cost increases on to their customers. If companies cannot raise prices enough to cover higher commodity costs, they may not be willing to pay high prices for commodities. That may be one reason why commodity prices have finally started to drop this month.

Many investors probably remember or have heard about "stagflation". This was an environment where the economy was weak but inflation still accelerated. Some analysts are using that term to describe the current economic climate. However, there are significant differences between the stagflation of the 1970s and the current mix of commodity inflation and housing deflation.

During stagflation, prices tend to go up in almost all areas, including wages, commodities and home values. Inflation persists despite a weak economy because rising wage inflation gives consumers more money to spend so they can afford to pay more for essential and non-essential items. In addition, rising home values make homeowners feel wealthier and this also makes them more willing to pay the higher prices. This combination of factors produced a wage-price spiral that persisted during various times in the 1970s even though the economy was weak.

The situation is very different today. There is commodity inflation and housing deflation at the same time. There is no wage-price spiral that can cause stagflation. Wage inflation has actually decreased this year as the economy weakened, and of course, home prices have dropped sharply.

As a result, commodity inflation has not pushed core inflation up significantly. For example, consumer price inflation including food and energy was 5.0% in the 12 months ended in June whereas core inflation which excludes food and energy was only 2.4% during the same 12-month period.

As the U.S. economy shifts further toward a service economy and less of a manufacturing economy, wages are a bigger factor in production costs than commodity prices. If wage inflation declines further, core inflation may remain moderate despite high food and energy prices.

The Fed expects inflation to moderate in coming quarters, but policymakers acknowledge that the inflation outlook is uncertain. Nevertheless, moderating wage inflation and falling home values suggest that the Fed's outlook may prove to be correct. For example, in today's Beige Book report, the Fed reported that wage pressures remain limited because of the soft labor markets.

In summary, wage inflation has moderated during the past year and a half as the economy weakened. This is what normally happens when economic activity slows. The risk of commodity inflation spreading to other parts of the economy would be greater if wage inflation was increasing, creating a wage and price spiral like the 1970s. That is not happening now. With wage inflation declining, home prices falling and commodity prices starting to decline, the overall risk of inflation may decrease. This could give the Fed more room to address problems in the housing market.

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