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Falling unemployment may trigger wage inflation

In a typical economic recovery, a drop in the unemployment rate like the one that occurred in the past year from 7.9% to 6.7% would be considered likely to spark wage inflation.

Falling unemployment normally helps to trigger wage gains as companies begin to compete for a dwindling supply of available labor.

The current recovery, which comes on the heels of a historic financial crisis, is different from many previous cycles, and is prompting debate about how far unemployment can fall before wage inflation emerges.

The Congressional Budget Office tracks the level at which the unemployment rate is expected to trigger inflation. This is called the Non-Accelerating Inflation Rate of Unemployment, or NAIRU. The level has risen during the past several years because of structural changes to the labor market, to approximately 5.5% in 2013. Today the NAIRU is below the unemployment rate of 6.7%, suggesting that employment gains are not yet putting pressure on wages.

But experts question the true level of the NAIRU and how much cushion actually remains before wage inflation emerges.

This debate is on the minds of Fed policymakers as they start down the path of reducing bond purchases meant to stimulate economic growth by keeping interest rates low and helping to spur demand. The Fed would like to see unemployment continue to decline, but must be watchful for an outbreak of inflation.

The NAIRU — the rate to which unemployment can fall without triggering wage inflation — as tracked by the Congressional Budget Office, is around 5.6%. However, our research suggests, and some institutions also have the opinion, that the NAIRU may be significantly higher than this, primarily because of various structural problems hampering the labor participation rate. Generally speaking, investors believe wage inflation could become problematic at higher levels of unemployment.

"If wage inflation develops earlier than the Fed is anticipating, we could see the central bank reducing its stimulus efforts much earlier than the markets are currently forecasting," says Bill Kohli, Co-Head of Fixed Income at Putnam Investments.

It is possible that economic growth in 2014 could be stronger than forecast, particularly during the second half of the year, Kohli believes. If that occurs, real interest rates — prevailing interest rates minus the rate of inflation — which have been negative since 2008, could significantly rise. "However," Kohli adds, "We don't believe rates are likely to rise so quickly that the shift will undermine the markets."

The views and opinions expressed are those of the speakers cited, are subject to change with market conditions, and are not meant as investment advice. All funds and investment products involve risk, and you can lose money. See the prospectus for details. Any economic and performance information is historical and not indicative of future results.

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