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Source: Macrobond, FS Investments.

Wage inflation is rising, a fact that can get overlooked as consumer inflation has remained well below the Fed’s 2% target for the past decade. Tight labor markets are driving much of this and arguably have room to push wage growth even higher. The path that wage inflation takes will be one of the most important pieces of the 2019 outlook and needs to be closely watched in Q2.

There are many measures of wage inflation. Of the four shown in the chart above, we have calculated a simple average to ease the discussion. Wage inflation is rising, although it remains below highs from prior expansions. Average hourly earnings rose 3.4% y/y in February 2019, the fastest pace so far this expansion. The employment cost index, a broader quarterly series, showed wages up 3.0% y/y in Q4 – also a 10-year high.

Higher wages have not spread to broader inflation but could still impact financial markets. Accelerating wages mean higher labor costs for companies, which can quickly impact profits. Indeed, in today’s global marketplace, price competition for consumers has intensified, limiting how much companies can pass through higher labor costs to the consumer. This may be good news for Fed officials concerned about inflation, but in the meantime corporate earnings may feel the squeeze.

We will be watching wages closely with a close eye on our simple average indicator. The most recent data showed 3.3% y/y growth in December 2018, still shy of the 4.0% y/y acceleration that coincided with the last time the Fed aggressively raised rates to pump the brakes on the economy in 2006.

The risk is that wage inflation accelerates sharply above 4.0% and feeds through to consumer prices and inflation expectations, thereby kicking off a classic wage-price cycle. The Fed would be in a tough but familiar position of needing to raise rates significantly more than markets expect, and would heighten the risk of a recession.

Read the analysis for each indicator:

Growth downshifts from sprint to sustainable

Consumer confidence
Housing market
Business investment

Interest rates dig in at historic lows

Fed rate expectations
International interest rates
Yield curve inversion
Wage inflation

A perfect storm of policy uncertainty

Policy uncertainty

Smooth sailing for high yield, headwinds for equities

Fixed income

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