In November another leading U.S. economic indicator took a turn for the worse: wage growth. Fortunately, this is one of the longer, slower leading indicators. History suggests this should not be interpreted as signaling a recession on the horizon, particularly when combined with improvements in commodities. The economic cycle should continue to chug on.
Yet this sudden blip calls into focus the broad influence of wages, which are often given short shrift. Rising wages are a double-edged sword for the U.S. economy. On the positive side, higher wages can help boost consumption, often the primary driver of U.S. economic activity.
Rising compensation can also bolster savings. Consumers are now saving 8.3% of disposable income, up nearly four times from the 2005 low. While higher savings has contributed to slower economic growth, it has helped strengthen consumer balance sheets. This should allow greater spending in the event of a sustained slowdown.
While higher wages are often a short-term benefit, over time they have the capability to do harm. A downside to stronger wage growth is the potential to hurt corporate profits. Wages are one of the largest expenses for most businesses, particularly in the services sector. Layoffs could result if companies cannot fully raise prices to offset higher compensation costs and maintain margins.
Rising prices can lead to inflation – and to a hawkish U.S. Federal Reserve that aggressively raises rates. Tight monetary policy and rising unemployment can be a powerful recessionary concoction, driving a negative feedback loop of slower consumer spending and diminishing economic activity.
Corporate profits typically get squeezed most when wage increases outpace productivity gains. Over the past five years, overall wage growth averaged 2.7%, well ahead of the 1% average increase for labor productivity (output per hour). This can take a significant toll on small businesses, the country’s primary employers.
Larger businesses also are experiencing margin pressures, with the contribution to growth from margins for the S&P 500 Index constituents having been negative for the last two quarters.
The latest data does not show wage pressure abating. While the headline figure for wage growth has softened a bit and is running at 3% per year, median wages are growing at a cycle-high 3.5%.
Demographic shifts partially explain the divergence between the average and median figures. As older, higher paid workers exit the labor force, they are replaced by younger ones at lower salaries. That pulls the average down. The median is less impacted by this dynamic and can be more representative of wage gains the typical U.S. worker is receiving.
But another source of wage pressure is coming from stronger raises for lower-earning workers.
Salaries for production and non-supervisory workers are growing at a higher rate (3.5%) than the 3% national average. Eighty percent of Americans have these types of jobs, which on average pay about half what the top 20% of Americans earn.
This divergence is evident in wage gains for the top and bottom quartiles of the labor force. While the early part of the expansion was defined by faster wage gains for the top earners, in 2015 it flipped. The bottom earners have been leading ever since, with very strong increases of 4.4% annually.
This can result in a short-term boost to consumption, as lower wage earners typically have higher propensities to spend. However, the longer-term drawbacks described above could play out too.
Can higher wage growth for lower-paying jobs be dangerous to the U.S. economy? Inflation has not been a recession risk for some time, but if such pay gains persist, we could have a new reason to worry.