Moving in the Right Direction

Last Friday we learned that the economy added just 20,000 jobs in the month of February, which was well below the consensus estimate and was the lowest in sixteen months. The news produced a small amount of market volatility, but that quickly faded as investors realized that several transitory factors were likely to blame. I agree with the collective wisdom of the markets. From my perspective, the labor market continues to produce encouraging developments. Not only have wages been growing at a relatively robust pace of over 3%, but inflation at the consumer level has cooled. The net effect of these two trends has been that the growth in real (inflation-adjusted) wages has surged to levels not seen since late 2015. Not only are workers earning more money, but they are also enjoying greater purchasing power. And perhaps even more encouraging, the recent trend of lower inflation has provided cover for the Fed to temporarily discontinue its interest-rate increases. In all likelihood, the Fed’s wait-and-see approach portends further wage gains to come. Higher middle-class incomes, stable inflation and low interest rates are a recipe for continued economic growth in an economy heavily dependent on consumer spending.

In the chart below, you will see that wage growth continues to accelerate despite a drop in inflation (as measured by CPI and PCE) over the past several months. The second chart shows the trend in wage growth after adjusting for inflation.

Source: Bureau of Labor Statistics

Source: Bureau of Labor Statistics

Faithful readers of our Market Commentaries are well aware of our concerns about the unbalanced nature of our 10-year-old economic recovery. Up until very recently, the relatively well-to-do have been enjoying the large majority of the gains in income, wealth, and spending over the course of the recovery. But while the well-heeled continue to do very well, thanks in large part to the stock-market recovery and lower taxes, we may finally be seeing greater participation for the middle class. Could this be the long-awaited inflection point toward greater economic equality? The answer to that question could depend on how soon the Fed resumes its process of normalization. For now, though, cooperative levels of inflation at the consumer level should keep the Fed firmly in “patient” mode.
There remains one troubling aspect to this narrative. The chart below shows several components of the Consumer Price Index (CPI), which is released each month by the Bureau of Labor Statistics. The Fed pays most attention to the black line because it represents all categories other than food and energy. Food and energy, which currently account for about 20% of total CPI, are excluded because their prices tend to be highly volatile. You will see that the black line has remained fairly stable at around 2% since late 2011. The Fed points to this stability as proof that its monetary policy has been successful.
Now look at the other four lines. These lines represent categories of spending that we would describe as “non-discretionary”, which simply means that nearly all families must spend money on these goods and services. These items collectively represent about half of the total CPI, with shelter currently accounting for an outsized 33% of the total CPI. It’s clear to see that inflation in these categories has been much higher than the metric upon which Fed monetary policy is based (the black line). In fact, taken together these items have grown at a 2.9% pace since 2011 compared to just 2.0% for the black line. (Transportation services prices have plummeted in recent months as airline fares fell due to lower fuel prices). Why is this disparity important? Because middle-class families must spend a disproportionate amount of their income on these categories. If prices for these non-discretionary categories have been growing at 2.9% for the past eight years and wages at much lower than that (2.3%, by my calculations), then middle-class families been getting squeezed. And this has been going on for a lot longer than the past eight years!
Source: Bureau of Labor Statistics
We’re hopeful that the wage gains we are seeing will be sustainable or even increase, but we remain highly mindful that this trend could end very quickly if/when the Fed feels threatened by higher inflation. For now, price levels should be contained as economies outside the US struggle, the trade wars continue, and we cycle the boost in 2018 from the tax cuts. At 3.8% unemployment, though, the Fed will likely have an itchy trigger if and when some of these issues are resolved.