Today’s data imply that the odds of a June Fed rate hike have diminished further. A September hike seems more likely now.
Private-sector wages and salaries rose at a 2.3% annual rate in Q4 after a 3% increase in both Q2 and Q3 2014, according to the employment cost index. In Q4 the y/y pace was 2.3%, up from 2.2% in Q3, 1.9% in Q2 and 1.7% in Q1 (see chart).
Implications for the Fed
On the margin, the only modest pick-up in the y/y pace probably implies that the odds of a June Fed rate hike, as we have been expecting, have diminished further. A September hike seems more likely now.
Economic growth has been strong for the past 1½ year or so, even considering today’s weaker-than-expected Q4 GDP report, see below. But for the Fed to raise rates, strong growth is not enough at this junction, because inflation is still tame.
Acceleration in wages would make the Fed more confident that inflation will trend back toward its 2% target – a necessary precondition for initiating rate increases, according to the December FOMC minutes.
Wages are picking up, but the pace is still not strong enough to suggest that the economy is very close to full capacity. Around 3% wage inflation would be normal at full employment (given around 1% productivity growth plus the Fed’s 2% inflation goal).
Still relatively weak wage pressures buy the Fed more time to access the outlook for inflation and global risks. As a result, the Fed might decide to delay lift-off in rates until September.
Q4 GDP: the economy is strong, despite a weaker-than-expected Q4
Real GDP rose at a 2.6% annual rate in Q4 after a 5% pace in Q3, the strongest expansion in 11 years. The consensus forecast was 3.0%, while our call was 3.2%. Weaker business investment and stronger imports were the key reasons why GDP disappointed compared to our call.
However, even with the weaker-than-expected Q4, real GDP expanded at a strong 4.3% annual rate in H2 2014, the strongest 6-month pace since H2 2003. Final domestic demand (GDP less net exports and change in inventories) rose 4.3% in H2 last year, the best since H2 2004 and a clear sign of domestic strength.
For 2014 as a whole, the economy expanded 2.4% after 2.2% growth in 2013.
For now, we expect 3.1% GDP growth in Q1 2015 and see clear upside risks to our 3.2% forecast for 2015 as a whole. With growth well above estimates of potential growth (our estimate is 2%) we should see a continued downtrend in the unemployment rate and hence more upward wage pressures, as also suggested by several leading indicators.
Within the GDP, final demand (GDP less changes in inventories) expanded at a disappointing 1.8% annual rate in Q4 after a 5.0% pace in Q3, which was the strongest since Q1 2006. Final domestic demand (GDP less net exports and change in inventories) rose 2.8%, down from a 4.1% pace in Q3.
Q4 GDP growth was supported by a strong 4.3% rise in consumer spending after a 3.2% gain in Q3.
However, the acceleration in consumer spending was offset by a slowdown in business investment, which rose a weaker-than-expected 1.9% after a very strong 8.9% gain in Q3. In addition, a sharply wider trade gap subtracted 1.0% point from Q4 GDP growth after a 0.8% contribution in Q3, as exports slowed (2.8% after 4.5% in Q3) and imports accelerated (a much sharper than expected 8.9% after -0.9%). Moreover, government demand fell 2.2% in Q4 after a 4.4% increase in Q3, in line with expectation, reflecting a correction in defense spending.
Residential investment increased 4.1% after a 3.2% rise in Q3. Inventories added 0.8% point to GDP growth in Q4 after a neutral contribution in Q3.
Consumer price inflation remains tame, though. In Q4 core PCE prices rose at a 1.1% annual rate following a 1.4% rise in Q3. The consensus forecast was also 1.1%. In Q4 the y/y pace was 1.4% after 1.5% in Q3.
ECI – the superior measure of wage growth
The ECI data support our long-held view that the US labour market is firmer than suggested by the still-tame average hourly earnings in the monthly jobs report. Thus, in December private-sector average hourly earnings were up a modest 1.7% y/y.
The ECI is a fixed-weight index. This prevents shifts in the occupational composition of the workforce from appearing as wage changes, as they do in average hourly earnings data in the jobs report. In other words, this means that a decline in the number of high-wage workers (miners, say) at the benefit of low-wage workers (retail clerks, say) will not appear as a decline in aggregate wages according to the ECI. Such a change would show up as a decline in the hourly earnings series, however, and that is why we consider it an inferior measure of wage growth.
Similarly, the demographic impact of more highly paid baby boomers retiring and replaced by younger lower paid workers would also show up as a decline in average hourly earnings, but not in the ECI.
Moreover, average hourly earnings do not track extra income growth in the form of benefits as the ECI does.
Nordea