Although the U.S. labor market has moved closer to full employment, real income growth is near zero. What will this mean for economic growth?

The economy continues to grow at roughly a 2% pace. While there have been sharp rises in business and household confidence, some of the hard data have not looked quite so good. Of course, to the extent higher confidence pushes up asset prices, it has real effects. It causes household wealth to rise, which pushes up consumption. Also, the cost of equity capital goes down, which helps the corporate sector. But these effects are relatively small, and they are currently being offset by other developments.

Real income growth is near zero

The rise in interest rates, for example, is a headwind for the housing market. But more importantly, headline inflation is rising at a time when nominal wages are growing at a stubbornly modest pace despite a tightening labor market. This means that real income growth has slowed sharply — indeed, it is now barely above zero. When higher inflation eats into stagnant wages, that takes a toll on consumption.

How much slack is left in the labor market?

The February labor market report showed another decent gain in total jobs, although warm weather in February probably boosted the numbers. Our guess would be that 20,000 jobs were effectively “created” by the weather last month.

When higher inflation eats into stagnant wages, that takes a toll on consumption.

Although the labor market is getting tighter, we believe there is some slack left in it, as illustrated by our employment ratio chart, which breaks down employment by age group. We think it’s clear that there is scope for employment to rise further, especially among young people. Our second chart shows the number of people who hold multiple jobs. We think that most people who hold more than one job do so because they can’t get a single job with a high enough wage, but it’s also the case that, when the job market abounds with opportunities, people will work multiple jobs as a way to make extra income.

The other important dynamic in the labor market is the interaction of the quit rate and wages. In a non-unionized labor force, the quit rate is the key transmission mechanism for wages. People receive higher wages by leaving their current employer for higher-paid work elsewhere. Historically, there has been a relationship between household confidence and the quit rate, but the recent rise in confidence has not pulled up the quit rate. Maybe people are not really as confident as they say? Or maybe the rise in confidence is heavily concentrated in employers, rather than among employees? Although it has not disappeared, the relationship between the quit rate and wages has been much weaker in the recent past.

Overall, this suggests that wages are not rising quickly enough to change the dynamics of the economy in an important way. Again, we think the data indicate that there is still some slack in the labor market, and that is why we think the Fed is still looking at two additional (or potentially three) hikes this year, but not more than that.

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