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Much commentary and public concern have focused on the evident trend decline in the share of U.S. national income flowing to labor (and the
corresponding trend rise in the share of U.S. national income flowing to capital). It seems timely to review the data on labor’s share of national
income in the U.S. economy historically – both the well-documented downward trend as well as the less-appreciated regular cyclical upswings in previous
economic expansions. While it is too soon to tell if the current expansion will – like prior expansions – feature a rise in labor’s share back toward
the historical average, there is some evidence of an acceleration in wages that is beginning to emerge in tandem with the ongoing decline in the
unemployment rate. If and when labor’s share of national income and wages rises and unemployment continues to fall, what will be the implications for
inflation and, in turn, the Fed?
Facts are Stubborn ThingsLabor compensation as a share of national income fell sharply in 2009–2010 and has remained depressed since then (see Figure 1). Indeed, labor’s 0.65 share
of national income at the end of 2013 was the smallest slice of national income paid to labor in at least 60 years!
While there has been justifiable focus on the downward trend in labor’s share, the chart also makes clear that in past business cycle expansions, there has
also been a pronounced cyclicality in labor’s share of national income. In the three expansions during the ”Great Moderation” – the quarter century after
Paul Volcker broke the back of inflation – labor’s share of income initially fell during the early dates of recovery and then began to rebound during the
expansion phase of the business cycle. Importantly, this rise in labor’s share occurred before, and usually well before, the business cycle peak and
continued as the economy fell into recession. The rise in labor’s share that occurs during recessions is well known and is usually attributed to the desire
of firms to “hoard” labor initially in downturns as sales decline – holding off on firing workers until the decline in demand is clearly expected to
persist. What is less well appreciated is the phenomenon of labor’s rising share of income well in advance of the peak in economic activity and for reasons
unrelated to labor hoarding.
Labor’s share and inflationIf the past is prologue with regard to labor’s share and, as in past cycles, it does begin to rise as unemployment falls toward the nonaccelerating
inflation rate of unemployment (NAIRU), what are the possible inflationary consequences? Interestingly, during the last three U.S. business cycles, the
rise in labor’s share that commenced during the expansion phase of the business cycle was not accompanied by a material rise in PCE inflation (see Figure
The contemporaneous relationship between changes in inflation and increases in labor’s share was negative in two of the last three business cycles –
inflation fell as labor’s share of income rose – and essentially flat in the 1997–2001 episode. So, at least since Volcker, there has been no automatic or
mechanical pass-through from a rise in labor’s share of the pie to PCE inflation. As it did during the Great Moderation, any pass-through, when and if
labor’s share rebounds in this cycle, will depend on three factors: productivity growth, pricing power and the policy rate set by the Fed.
All eyes on the three PsThe markets will be following closely how labor productivity and company pricing power evolve in tandem with compensation costs in coming quarters. The
most favorable scenario for workers? Labor’s share of income rises in tandem with a combination of stronger productivity growth and, perhaps, some profit
margin compression to produce a “goldilocks” outcome – a boost in the purchasing power of real wages without an unwanted surge in inflation significantly
above the Fed’s 2% target. On the other hand, an unfavorable scenario for all concerned would be a rise in labor’s share accompanied by a productivity
slowdown and aggressive efforts by companies to maintain existing profit margins at or near record peaks as a share of national income. In this case, the
economy could face at least a whiff of stagflation. During the late 1960s and the 1970s, as inflation and inflation expectations began to rise, increases
in labor’s share were largely passed through to headline inflation, in stark contrast to the post-Volcker track record. In fact, the all-time peak in
labor’s share of income, 0.7127, was recorded during the 1980 recession, when PCE inflation exceeded 10%.
No one – certainly not this author – is predicting a return of labor market clout with the bargaining power to fuel double-digit inflation. But even with a
modest increase in inflation from current levels, the Fed could face a situation in which real wage gains and falling unemployment – both welcome – occur
in tandem with a rise in inflation above the 2% target. That said, Fed officials have emphasized that 2% is an inflation target, not a ceiling, and that
inflation has, in fact, been running below 2% since 2012.
Thus far in the recovery from the Great Recession, the Fed has not faced a tradeoff between achieving its dual mandate objectives. Unemployment has been
too high and inflation has been too low. Those days may well be coming to a close, and if so, the Fed will need to provide more guidance than it has so far
about the “balanced approach” it says it plans to follow as it normalizes policy rates.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material
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strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this
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AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively,
in the United States and throughout the world. ©2014, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2015, PIMCO.
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