Labor And Inflation: Share and Share Alike????? by Richard Clarida, PIMCO

  • Labor compensation as a share of national income fell sharply in 2009–2010 and has remained depressed: The share of national income at the end of 2013 was the smallest slice paid to labor in at least 60 years!
  • 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.
  • 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.

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 Things

Labor 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!

Labor share

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 share

Labor’s share and inflation

If 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 2).

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.

Labor share