Global Macro Matters: Higher inflation? Follow the money . . .

Wage pressures are a "canary in the coal mine" for trend inflection points. Over the past three decades, the public's expectations for future inflation have been a critical factor influencing core inflation trends. Inflation expectations are reflected in the link between wages and prices. As consumers begin to expect higher prices in the future, they may bargain for higher wages, which firms then pass along in the form of price increases. We view wages as a real-time indicator of the amount of slack in the market.

Wages and inflation expectations are significant drivers of future inflation

Note: Chart is based on inflation-variance decomposition described in Evolving U.S. Inflation Dynamics: Explanations and Investment Implications, by Joseph Davis (Vanguard, 2007). Sources: Vanguard, based on data from U.S. Bureau of Labor Statistics, Federal Reserve Board, Bridge/Commodity Research Bureau, and Federal Reserve Bank of Philadelphia.

Wage growth not inflationary yet

Growth in U.S. wage metrics, including a weighted wage composite, has been modest, falling short of the 4% watermark for average productivity growth (~2%) and the Federal Reserve's long-run inflation target (~2%). As of April 30, 2014, wage pressures are a far cry from those that preceded the high inflationary periods of the 1970s and 1980s. Our analysis of wage patterns suggests that, in an otherwise disinflationary world, U.S. core inflation is bottoming and should gradually rise toward the Fed's target.

Wage metrics point to moderate core inflation

Notes: Green dots reflect the most recent observations for a wide array of wage metrics; four examples are labeled. Inflation lead time represents point of strongest correlation between change in year-over-year growth in each factor in the figure and year-over-year growth in core-CPI inflation. ECI = Employment Cost Index. Sources: Vanguard, based on data available as of April 30, 2014, from U.S. Bureau of Labor Statistics and U.S. Bureau of Economic Analysis.

Minimal wage pressures across United States

U.S. labor markets are now less impaired than in 2009, but wage pressures remain moderate. The lone state with both very low unemployment and high wage growth is North Dakota, which represents less than 0.5% of the nation's workforce. Across U.S. industries, significant wage pressures are limited. However, Vanguard is closely monitoring increasing anecdotal accounts of skilled labor shortages for signs of mounting pressures.

Most U.S. state labor markets not yet 'tight'

Notes: Intersection of x- and y-axes in the figure represents 4% wage and salary growth and 5.4% unemployment. Unemployment growth represents Fed’s estimate of non-accelerating inflation rate of unemployment (NAIRU). Sources: Vanguard, based on data from U.S. Bureau of Labor Statistics.

Fed's target is in view, but may be closer than it appears

Based on our estimated Phillips curve, Vanguard's view is that the Fed's current forecast of stable inflation and full employment (the "bull's-eye" in the chart) by 2016 is reasonable. However, as with any forecast, there are risks. Among our concerns is the possibility that unemployment could drop below 6% before year-end, implying poor labor force growth. Should this occur, acceleration in core inflation may emerge sooner than the Fed currently expects. Looking forward, we would view the combination of broad-based wage growth in excess of 4% and still-negative real short-term rates as a signal that the Fed's policy stance was "aiming too high," increasing inflation risk.

History suggests we are on target for full employment and stable inflation

Note: Chart is based on policy target framework proposed by Federal Reserve Bank of Chicago President Charles L. Evans (in "Like It or Not, 90 Percent of a 'Successful Fed Communications' Strategy Comes from Simply Pursuing a Goal-Oriented Monetary Policy Strategy," speech delivered to U.S. Monetary Policy Forum, New York City, February 28, 2014). Sources: Vanguard, based on Evans (2014) and data from U.S. Bureau of Labor Statistics, Federal Reserve Bank of Philadelphia, and U.S. Congressional Budget Office.