The answer to the slow wage-growth puzzle: baby boomers

The U.S. economy added 200,000 jobs in January, led by a 55,000-jobs gain in the goods-producing sector and a solid 127,000 jobs advance in the services sector. Within the goods sector, construction employment led the advance with 36,000 additional jobs, while manufacturing employment increased by 15,000 jobs.

On the services side, the health-care and education sectors added 38,00 jobs while restaurants hired 35,000 workers. Interestingly, while the retail sector added a moderate 15,000 jobs, the transportation and warehousing sector gains pointed to ongoing strength in online sales.

{mosads}Overall, the employment trend remains quite firm with the 12-month trailing average — a less volatile gauge of job growth — showing the economy on track to add more than two million jobs in 2018.

The unemployment rate remained flat at its 17-year low of 4.1 percent as the labor force participation rate was unchanged for the fourth month in a row at 62.7 percent.

Importantly, hourly earnings of private sector workers picked up a solid 0.3 percent in January, after a strong 0.4-percent uptick in December, pushing wage growth to 2.9 percent, year-over-year (y/y) — the fastest pace since June 2009!

These latest observations are encouraging as they indicate that the momentum at the end of 2017 has permeated into 2018. Indeed, the Employment Cost Index (which accounts for compositional shifts in the labor force) grew 2.6 percent year-over-year in the fourth quarter, up from 2.5 percent y/y in the third quarter.

The gains were broad-based, with the all-important private-sector wages and salaries component rising 2.8 percent y/y, its fastest pace since 2008!

While these latest data readings will certainly make the headlines, it is important to note that overall wage growth remains moderate, and earnings adjusted for inflation are only growing about 0.8 percent y/y.

Some commentators have argued that given the historically low unemployment rate, wage growth should be much stronger than the current 2.9 percent y/y in January. The absence of significant wage pressures given the historically low unemployment rate has led them to conclude that the traditional trade-off between unemployment and wages — the infamous Phillips curve relationship — no longer exists.

However, a closer look reveals that while the Phillips curve has flattened substantially over the past 20 years, the trade-off between unemployment and wages remains in place; it is simply weaker than before.

When examining the causes for the flattening of the Phillips curve, we find that wage inflation is being held back by several key factors, notably, low productivity growth and low inflation.

Indeed, a framework that combines trend productivity growth (as a proxy for the marginal value of employees), lagged inflation (to account for the backward wage-setting process) and unemployment tends to track actual wage growth fluctuations with reasonable accuracy.

Further, one of the most under-appreciated facts about the U.S. labor market stems from the rebound in the labor force participation rate. “Fake news” you say? Not really, rather, this is “informed news.” The increasingly rapid retirement of baby boomers has skewed the official BLS statistics, and a look under the covers reveals a very different trend in labor market participation.

The labor force participation rate remained unchanged for a fourth consecutive month at a historically low 62.7 percent in January 2018 — in the middle of its four-year range of 62.6-63.1 percent. At first glance, this could indicate a full-employment labor market with relatively little churn.

However, the reality is that the structural aging of the U.S. population has skewed traditional statistics. Since the first baby boomers started retiring in 2011, there has been an increasingly strong structural drag on the official labor force participation rate.

Case in point: While the official rate is marginally lower than in January 2014 (62.7 percent versus 62.8 percent), the age-adjusted measure has risen 0.9 percentage point over the past four years!

Looking more into the details, the age-adjusted labor force participation rate is only 1 percentage point below its pre-recession level, compared with a 3.5-percentage-points shortfall for the official statistic. This is important to understand for two reasons:

First, the so-called “Silver Exit” from the labor force — the retirement of baby-boomers with above-median wages — has been and will continue to limit average wage growth.

Second, the strong rebound in the age-adjusted labor force participation rate indicates that the economy is not quite at full employment, and that returning labor market participants are also imposing a modest restraint on wage growth.

As such, we should expect to see ongoing “gradual” firming of wage growth supported by a progressive acceleration in productivity growth, modestly stronger inflation and ongoing reductions in labor market slack.

Gregory Daco is the chief U.S. economist for Oxford Economics, a global forecasting and economic analysis consultancy.