Macroeconomics

26 June 2017

Behind the curve 

Compared to most economic theories, the so-called “Phillips Curve” couldn’t be simpler. Developed by the New Zealand economist William Phillips, it argues that there is an inverse relationship between unemployment and inflation: when one goes up, the other should come down.

By the same logic, wages should stagnate when unemployment is high; when unemployment levels come down, wages should then rise.

While that sounds commonsensical, it is not what we are seeing across much of the developed world. Instead, as the job market continues to tighten, wages are barely budging. 

So why are so many markets behind the curve? 

Let’s start by looking at the United States, where unemployment stands at 4.3%, the lowest rate in 16 years. At the same time, amidst the country’s third-longest period of economic expansion on record, inflation remains below the target set by the Federal Reserve. 

The fact that the US core inflation rate declined to 1.7% in May at least partly explains why average hourly wage growth remains anemic, rising just 0.2% over the same period. In this context, employers are obviously under less pressure to raise salaries to compensate for the (minimal) increase in the cost of living. 

Still, tight labor conditions typically mean that employers have to pay more to retain and attract staff. And that’s just not happening. 

Indeed, we see the same in other low-inflation, low-unemployment markets, such as Germany. There, the jobless rate declined to 5.7% last month, the lowest level since reunification in 1990, but wage growth remains subdued. Again, that may be partly a reflection of core inflation, which stands even lower than in the US, dipping to just 1.3% in May. 

In the UK, the situation is more closely aligned with the Phillips Curve – unemployment has come down to 4.6%, while inflation has trended upwards to 2.9% – but the wage outlook is even more alarming than in the US or Germany. 

Despite enjoying the lowest jobless rate in over four decades and increasing inflationary pressure, UK average earnings are stagnant. Adjusted for inflation, wages were in fact down 0.6% in April compared to the same period last year, exacerbating conditions for Britain’s increasingly large population of working poor. 

In all of these markets, especially given the political pressure to take action, what exactly is holding back wages? 

First, not all kinds of employment are the same. In the US, for example, food services was the fastest-expanding sector in May, while the number of higher-paying manufacturing jobs shrank. In the same month, new available jobs in London’s financial sector fell 16% compared to May 2016. 

German wages are being impacted by a host of factors, including an influx of lower-paid immigrant workers, an ongoing decline in union membership and collective bargaining, and a steady rise in part-time employment.  

Policymakers have taken particular note of the situation in Germany, with the International Monetary Fund warning that wage growth is urgently required to increase the country’s purchasing power and support the broader eurozone recovery. 

Finally, it’s worth noting that, as any market approaches so-called “full employment,” the last to be hired are typically the lower skilled and less experienced. Unsurprisingly, that segment is paid less than those already part of the labor force – driving down the median. 

All of this doesn’t necessarily imply that the developed world should brace itself for the kind of stagnation that Japan has struggled with for two decades. Over that period, average wages have never risen by more than 1% annually – despite an unemployment rate consistently in the low single digits, currently standing at 2.8%, and likewise low inflation. 

While Japan’s economy has not conformed with the Phillips Curve for the last 20 years, there are exceptions to every rule. Moving forward, the question is whether the rule itself will become obsolete.