A Little History Of Wages, Inflation, Treasuries And The Fed - And What We Learn From It

by: George Dorgan


Inflation expectations and wages drive the behaviour of the Fed and Treasury bond yields.

Excessive wage increases lead to recessions, more or less voluntarily caused by central bank tightening.

Central banks pin down the short end of the yield curve, while financial-market participants price longer-dated yields.

Some Emerging Markets seem to copy strong wage increases and inflation that we lived in the 1970s.

Rising wages in EM may soon narrow their competitive advantage against the U.S. and Europe. Our secular stagnation may be shorter than expected.

In most periods, inflation expectations and wages remain the main drivers of US bond yields. Inflation and its early indicators, like money supply or inflation expectation surveys, are the main determinants of the Fed's behaviour. The inflation expectation surveys are often closely related to wages. Expected wage growth is often met by effective wages and inflation after some time.

Until 1985, inflation expectations and wage development drove the behaviour of the Fed: when wages rose too quickly and when those were translated into higher sales prices and high price inflation, then the Fed had to hike rates. Consequently credit and investments became more expensive, costs became too high. Entrepreneurs reacted and fired workers. Thanks to higher unemployment and a recession, inflation expectations and the speed of wage improvements fell again. With the recession the Fed restored the equilibrium in GDP growth between growth caused by rising profits of businesses and growth caused by rising wages. The following graph shows how excessive total wage payments were an indicator that predicted a recession or a considerable slowing. In particular the point when wage rise significantly more than company margins, is of interest. The NAIRU aka an unemployment rate that is too low to be able to stop inflation, is closely associated with that point. When we speak of total wage payments this includes two effects: higher pays and more people in the labor force.

At the end of the 1950s, a total of 8% higher wage payments per year predicted a recession. In 1978 this value rose to 13%, sustained by rising oil prices and spending and quickly rising wages even in Germany. In 2005 this indicator achieved only 6.5% higher wage payments p.a. but it was already enough to predict a recession.

In 1978 this value rose to 13%, sustained by rising oil prices and spending and quickly rising wages even in Germany. In 2005 this indicator achieved only 6.5% higher wages p.a. but it was already enough to predict a recession. The parallel movement of the red and the green line shortly before the recessions show how the Fed hikes rates in order to stop the wage excesses.

Click to enlargeThe peak of inflation expectations was in the early 1980s, 10 year Treasury yields topped at 19% during a wage-price spiral. Volcker managed to beat excessively high inflation and wage expectations. When he kept short-term rates high for a longer time, refinancing for banks became expensive. Money supply and today´s unpopular GDP growth driver, called "credit growth" fell again. With lower wage expectations, workers could not anticipate their future earnings with loans like they did before. Furthermore, it reduced the distance between rapidly rising wages in the US compared to countries with a slower "wage hike pace" like Germany and Switzerland. Finally, the dollar stabilized again. The concept called "productivity" = GDP divided by worker and stock markets edged up again after years of poor performance.

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From 1985 to 2004, the old picture returned: inflation expectations drove the Fed and bond yields. But now both nominal and real yields fell during the following period that we call here the Great Disinflation. The inflation risk premium, the difference between 10 year yields and core inflation, is clearly visible. It contracted more slowly than yields so it arrived finally at values close to zero in 2011 and 2012. TIPS, the green line above, are an alternative to core inflation or short-term rates to compute the inflation risk premium.

Since 2004, the Fed Funds rate seems to have been completely decoupled from 10 year yields. It moved up and down between 0.25% and 5.5%, but the 10 year yield continued to fall nearly steadily until 2012. We believe the reason is that wealth in emerging markets rapidly increased and therefore the United States is slowly losing its status as the unique global reserve currency. In Southern Europe and partially in the U.S. workers thought that salaries should keep rising nearly as much as they were augmenting in China. Germany, Japan and Switzerland, however, decided to leave their labor force competitive.

The Fed ended the spending and wage hike party based on a housing bubble from 2005 onwards. Already in 2006, proprietor's income rose less than wages. Since economic developments were much more globalized, the boom continued somewhat longer in Europe and the rest of world, while the U.S. housing bubble already popped in 2007. The Fed lowered rates despite continuing spending excesses. This let to a completely grotesque 2008, when the oil price topped at 150$ and collapsed some months later to 30$.

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With the so-called Great Stagnation, U.S. wages stopped rising quickly and households adjusted their saving rates from around 0.5% before the crisis to more sustainable values of 5% after the crisis. Emerging Markets [EM], however, continued their wage recovery against advanced economies. Already in 2010, it became clear that thanks to QE1 and Chinese fiscal expansion, EM wages and spending continued rise. This helped to avoid a longer-lasting global crisis. With higher wages, most of EM maintained high household savings rates, but company margins in EM slowly eroded. Chinese stocks could never achieve the highs of 2007/2008 again.

The opposite picture in the U.S.: The equilibrium between entrepreneur profits and wage contribution to US GDP growth has completely moved to the favour of entrepreneurs (see in table above under "Proprietors Income"). Piketty's book "Capital in the 21st Century" describes well the symptoms. But Piketty does not really understand that rising wages and inflation squeeze profits of entrepreneurs in emerging markets and stock market valuations there, but EM spending power increases profits of global U.S. companies. Moreover, investments of U.S. firms in emerging markets do not really contribute to US GDP, while investments in the US remained subdued at least until early 2013. Wage costs in EM appeared still to be low enough to prefer investments outside of the U.S. But now the picture is changing: Russian GDP is mostly driven by years of rising salaries and higher consumption but thanks to high rates, not by investments any more. Brazilian industrial production is falling due to high inflation expectations and high rates. Some more examples of how much wages in emerging markets are still rising: here and here.

Claudio Borio of the Bank of International Settlement speaks of high risks that EM currencies will collapse this year again. This collapse would make their wages in global comparison cheap again but capital should get expensive. We think that it could rise from 5% yield per average EM bond issuance today back to 8% as some years ago. An important exemption from this rule, however, is China. China has accumulated far more capital than any other EM and is able to limit wage hikes thanks to its totalitarian regime and the Asian collective mentality.

We understand that many Emerging Markets are now copying the wage excesses in the U.S. and Europe lived in the 1970s and early 1980s. No wonder, as for economic developments, in particular for the availability of financing they were 20 or 30 years behind us. Many Western countries have arrived in a rather saturated stadium.

We think that there are two types of Emerging Markets, the ones with rather autocratic governments and collective societies, like in China (NYSEARCA:FXI), Vietnam (NYSEARCA:VNM), South Korea (NYSEARCA:EWY), Malaysia (NYSEARCA:EWM) or Bangladesh, where thanks to wage oppression, investments still makes sense. With high income in commodities, an autocratic government and a very hawkish central bank, Russia (NYSEARCA:RSX) rather belongs to them.

Other EMs are too democratic or too individualistic: The major ones are Brazil (NYSEARCA:EWZ), India (NYSEARCA:PIN), South Africa (NYSEARCA:EZA), Turkey (NYSEARCA:TUR) , Argentina (NYSEARCA:ARGT) and maybe also Indonesia (NYSEARCA:IDX). Central banks must often obey to political pressure, which leads to a depreciating currency and continuing wage pressure but rising financing costs.

For us the BRICs got finally split, just as Jim Rogers had predicted.

The other thing, however, is that wages are always a question of relative competitiveness. When they rise quickly in Emerging Markets, then there is a big chance that the secular stagnation in the U.S. or in Europe will not be as long as expected.

Read more:

More about bond yield drivers on our page: What determines government bond yields.

and Jim O'Neill's Bullish BRICS Outlook until 2020 and our Critics

Disclosure: The author is long RSX. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Apart from RSX no position in mentioned ETFs.