Today’s report on the U.S. Consumer Price Index (CPI) for April together with the April employment report appear to offer textbook examples of a functioning relationship between labor and inflation in the U.S. economy.
Our base case for 2016 is that the Federal Reserve has to facilitate a delicate transition from job growth to wage growth. The idea is that as the U.S. economy reaches full employment, job growth will converge toward labor growth, but this will come with an increase in wages.
While April’s addition in nonfarm payrolls of 160,000 was on the low side of expectations, we believe it is consistent with what to expect for 2016. Actually, one could argue it was a steamy number for an economy with an unemployment rate at 5.0% and labor force growth of only 80,000 per month. Logically, the strength of the labor market is starting to feed into better wages. The 2.5% year-over-year growth in average hourly earnings is moving in the right direction – it didn’t even average 2% between 2010 and 2013. The wages version of a Phillips curve (the theoretical relationship between unemployment and earnings, where wages rise as unemployment drops) is at work in the real economy (see Figure 1).
Turning to the CPI data (see Figure 2), here too the real economy is functioning surprisingly in line with theory. Core goods (mainly stuff we import) posted a small decline at -0.1% month-over-month, the lag effect of a stronger dollar and global disinflationary forces that will weigh on the tradable sector in 2016, though we expect this headwind too shall pass. Core services (mainly stuff that’s labor-intensive or sensitive to the domestic economy) increased by a healthy 0.3% month-over-month. This is where loose monetary policy and a healthy U.S. economy are most likely to have an impact on prices, and it’s working.
Altogether, the core CPI of 2.1% year-over-year met our expectations, and we believe it will end the year between 2% and 2.2%. Inflation is slowly moving back toward the Fed target. We also believe the Fed should remain patient and let inflation run a bit hot to compensate for the large miss of recent years; its patience could also help re-anchor inflation expectations higher.
Today’s good news is the U.S. economy is functioning as Macroeconomics 101 says it should. This should help reduce the fear of left-tail events and of seeing the U.S. fall into a long-term deflationary trap.