What might drive share prices up in coming months? One answer is: something that doesn’t seem to exist now.
This something is the Phillips curve. Named after the New Zealand economist Bill Phillips, this is the idea that lower unemployment leads to higher wage inflation.
This, however, has not been the case recently. US figures show that wage inflation has moved sideways for the past two years (except for the odd blip such as the one that triggered the stock market’s sell-off in February) even though unemployment has fallen to an 18-year low.
It’s not just in the US that the Phillips curve seems to have vanished. In the UK, wage inflation is lower now than it was three years ago even though the unemployment rate has fallen to its lowest level since 1975. And in the eurozone wage growth is lower now than it was in 2011 while the unemployment rate has fallen by two percentage points since then.
All this should be great for equities. If economies can continue to grow without creating inflation then interest rates can stay low for longer. That should prolong the upturn and sustain the 'reach for yield' that has driven investors out of cash and into shares. By the same token, any rise in wage inflation would trigger fears of higher interest rates and slower growth, to the detriment of shares. The fact that global share prices fell in February after news of a rise in US wage inflation, but have recovered since as that rise was reversed, shows that stock markets are very sensitive to the question of whether the Phillips curve will re-emerge or not.
So, will it? Here, two big facts collide. One is that there’s nothing new about an apparently elusive relationship between unemployment and wage growth. As Oxford University’s James Forder has shown, Phillips’ attempt to establish a close link between the two was based in part on weak and massaged data. The Phillips curve has always been unstable.
On the other hand, though, common sense says that there must be some relationship between unemployment and wage inflation. Excess supply drives prices down and shortages push them up. This is true of all markets, so why shouldn’t it also be true in labour markets?
We can reconcile these two facts by thinking of wage inflation as the outcome of bargaining between workers and employers. Wages rise when workers have the power to extract pay rises. The unemployment rate, however, is only one of many indicators of this power. There are many more, such as the strength of trades unions or the generosity of welfare benefits or level of minimum wages. Several developments recently explain why workers don’t have much bargaining power, despite low unemployment. These include:
- Hidden unemployment. On top of the 1.4m people who are officially unemployed in the UK there are 2m out of the labourforce who want a job. Similarly, in the US a wider measure of unemployment is twice as high as the official one. There are more workers competing for jobs than headline numbers suggest.
- Productivity growth has slowed in the US, and stopped completely in the UK. The economic pie over which bosses and workers are negotiating isn’t growing. So the amount workers can get cannot grow.
- An atomised workforce. The Bank of England’s Andy Haldane said last year that workers are now more fragmented than before; the decline of trades unions is only one gauge of this. This means workers are less able to push collectively for higher pay.
- Openness. Western workers are competing against lower-paid foreigners. This isn’t because of immigration, but because of competition from cheap imports (imports are a form of crystallised labour) and the threat of factories and call centres moving abroad.
- Scarring. In the 1950s wage growth stayed low despite genuinely full employment. A big reason for this was that workers remembered the mass unemployment of the 1930s and so were scared to push for higher wages; it was only when the cohort of workers who remembered the Great Depression retired that wage militancy rose. Similarly, memories of the 2008-09 recession might well be suppressing wage demands today.
If these factors stay in place, wage growth will stay low and so there’s less chance interest rates will rise so much as to choke off growth. That should be good for shares?
But will they remain? Truth is, nobody knows. Aggregate wage inflation is determined by countless dispersed decisions based on thousands of local industry-specific factors. And as the Nobel laureate Friedrich Hayek said, nobody can possibly know all these factors.
We do know something, though – that if central bankers do raise interest rates significantly then we shall never know how low unemployment can fall without triggering higher wage inflation.
