Sturdy job growth has been the one constant amid the ebbs and flows of the economy's current expansion. The economy is on track to create a robust 2.5 million jobs this year, about the same gain as in the previous three years. The private sector has consistently added to payrolls for nearly six years, the longest string of consecutive gains on record.
At this pace of job growth, the unemployed and underemployed are being quickly absorbed. In the wake of the Great Recession, a disheartening more than 6% of the labor force wasn't working as much as it would like. Today, less than 1% of the labor force is in this tough position. And if job growth holds firm, which seems likely, the labor force will be fully employed by next summer.
Wage gains are finally picking up, more consistent with the fast-tightening job market. Both average hourly earnings and wages as measured by the employment cost index have accelerated noticeably over the past year and more. This is particularly impressive since both inflation and productivity growth, the determinants of wage growth in the long run abstracting from the amount of slack in the labor market, have slowed. The wage pickup is especially strong in industries and regions of the country that have already returned to full employment.
There has been some consternation among economists that the so-called Phillips wage curve, the long-standing relationship between wage growth and slack in the labor market-has broken down. This is not the case. The shape of the curve has gotten flatter -- wage growth isn't as sensitive to a given change in slack -- due primarily to stable inflation expectations, but the curve is alive and well.
In the long run, when the economy is at full employment, wage growth should be near 3.5% per annum. This is equal to the sum of 2% inflation -- the Federal Reserve's target -- and 1.5% estimated trend productivity growth. This suggests there will be a further substantive acceleration in wage growth in coming quarters.
Better wage growth will provide a substantial boost to the broader economy. The obvious link is through increased personal incomes, which will further support already-healthy gains in consumer spending. Less obvious, but also important: Stronger wage growth should lift consumer confidence.
Sentiment has recovered substantially since the recession, but it is still well short of the euphoria felt during the best of times in past recoveries. Most people's perceptions about their own finances and the economy are formed through the prism of their pay. Did they get a pay increase this year? Was it bigger than last year's increase? Was the increase bigger than the growth in living costs?
Until recently, the answer to these questions was a resounding no. However, as this changes, and more people enjoy bigger pay increases, sentiment should improve. Confident consumers make bigger, more discretionary purchases such as buying a car or home, taking a trip or getting elective surgery.
Full employment and stronger wage growth will also be the catalyst for more household formations. While household data are notoriously poor, it is clear and not surprising that formations slowed sharply during the Great Recession. From mid-2007 to mid-2012, formations were running at a weak near 500,000 per annum. For context, in a typical year given the growth in the population and the population's age and ethnic distribution, formations should be closer to 1.15 million per annum.
Simple arithmetic (1.15 million less 500,000 times five years) would suggest that 3.25 million households that would normally form during those tough times, didn't. According to the Census Bureau, this is roughly equal to the increase in the number of Millennials -- those between the ages of 20 and 34 -- living with their parents during the period.
Most of these Millennials will eventually form households as better job opportunities develop. Indeed, there are signs they already are, as formations appear on track to top 1.25 million this year. Even under conservative assumptions, it seems reasonable to expect that at least 1.5 million households will form on average each year over the next several years.
More households mean more housing. Builders have put up 1.1 million homes over the past year. With rental and homeowner vacancy rates about as low they ever go, housing construction should ramp up considerably. Moreover, until homebuilding catches up to household formations (and then some, given the need to build homes to meet second-home demand and obsolescence), vacancy rates should continue to decline, adding more fuel to already-strong rent and house price growth.
Re-attaining full employment will be a significant achievement, as it will have been nearly a decade since the economy was last operating at full-tilt. There has been an almost overwhelming amount of financial pain and suffering in the interim.
But while full employment will feel good, it will focus the problems created by the slump in productivity growth. Unless productivity growth returns to life soon, GDP growth will slow sharply. Throughout much of the recovery, the gains in GDP have been largely driven by the strong employment gains. However, once full employment is achieved, job growth can't be greater than labor force growth for long without fomenting undesirable wage and price pressures.
Is Productivity Slowdown Overstated?
To get a sense of the implications, consider that nonfarm business productivity growth over the past three years has averaged only 0.5% per annum. Assuming that labor force growth is close to 0.75% per annum, this means that sustainable GDP growth would be no more than 1% per annum (the sum of labor force growth and economy-wide productivity growth, which is about 0.25 percentage points less than nonfarm business productivity growth). Of course, this would be incredibly disappointing, with hugely negative implications for many things, including the growth in our living standards.
To be sure, the slump in productivity growth is likely overstated. There is increasing evidence that the Bureau of Economic Analysis is undercounting investment in information processing equipment and growth in the rapidly expanding information services sector. The BEA is unable to keep up with the implications of changing technologies and preferences on output.
However, these measurement problems account for only 0.25 to 0.5 percentage point of output growth per annum. Thus, productivity growth appropriately measured is still much weaker than historical experience and what most policymakers and economists expect in coming years.
Indeed, there should be productivity growth to soon stage a substantive rebound. Behind this perspective is that recent productivity gains have been depressed by a number of cyclical forces that are abating.
Most notable is the heretofore weak labor market and resulting low labor costs. With wages barely keeping pace with inflation, businesses have had little incentive to invest in labor-saving technologies. Now that full employment is in sight and wage growth is accelerating, businesses are likely to refocus on how to improve productivity to keep their labor costs down.
Investment during much of the recovery had also been flowing into the rapidly expanding energy sector. Oil production has nearly doubled during this period, as investment in fracking technologies and processes surged. This investment did nothing to support labor productivity. Now with oil prices and energy investment off sharply, more investment dollars are expected to flow into labor-saving investments, particularly in information processing equipment and software.
Regulatory and legal requirements imposed on the financial system following the crisis have likely also weighed on productivity. The system has needed to substantially increase its capitalization and liquidity, and ramp up the investment and labor resources devoted to stress-testing and other forms of regulatory compliance. Surprisingly, weak productivity growth in other countries with large financial sectors, such as the UK, is consistent with this explanation.
There are reasons to be fearful that productivity growth will not rebound as anticipated. Most disconcerting, new-business formation, a fountain of innovation that is vital to future productivity growth, remains abnormally low. Formations contracted during the recession and, while they are off bottom, they remain far from pre-recession levels across nearly all industries and regions of the country.
Labor mobility, which is important to matching workers with jobs that maximize their skills and talents, also appears depressed. This may be related to the aging of the population -- baby boomers in their 50s and 60s aren't likely to switch jobs -- and the ascent of star companies that dominate their industries, such as Google or Goldman Sachs, which pay workers so well that they don't leave, even if there is a job better suited for them elsewhere.
There are other risks to the economic outlook. The economic slowdown in China and other emerging market economies is a threat. So too is the expected increase in volatility in financial markets as the Federal Reserve normalizes monetary policy. But arguably the most serious threat is that productivity growth does not soon kick back into gear.