Fitch: Sharp US Wage Shock Could Cause Global Tightening; Major Slowdown
A domestic US wage cost shock could lead to substantial financial tightening, which would result in a significant slowdown in the world economy, according to a new global macro scenario report from Fitch Ratings. In the report Fitch economists explore the consequences of a much faster-than-expected pick-up in US wage growth and the impact on economic growth, Fed policy and bond yields as well as international macroeconomic spillovers.
"Fitch's baseline forecast is for US wage growth to pick up gradually, which would support household incomes and help bring inflation back to target as the Fed gradually normalises policy, but a very sharp increase in US wage inflation would be problematic," said Brian Coulton, Chief Economist, Fitch. "A surge in US wage inflation would prompt the Fed to hike rates much more quickly than expected and threaten the lower-for-longer market consensus on interest rates that underpins current very low bond yields."
The failure of US wages to pick up sharply in the last few years despite the fall in unemployment has cast doubt on the validity of any inverse relationship between the unemployment rate and wage inflation. However, modest wage inflation in the last couple of years may have been partly explained by the strengthening of the dollar and the fall in energy prices after mid-2014, which pushed down US consumer prices and boosted purchasing power. As the impact of these shifts on consumer price inflation fades the traditional inverse relationship between wage growth and unemployment may reassert itself. Some indicators of US wages (including the Atlanta Fed wage tracker) already show signs of acceleration.
"The emergence of significant domestically generated US inflation pressures would represent a big shock to the current market consensus that the Fed will be able to continue on a very gradualist path towards normalising monetary policy," added Coulton. "In this scenario there would be a risk of a rise in bond yields from current low levels, which appear to be pricing in a fairly low level of future interest rate volatility."
Fitch has examined a scenario where US wage inflation rises swiftly to over 5% by 2018 and US and global bond yields increase by 100 bps (relative to baseline). These shocks - combined with an assumed rise in global risk aversion in the form of a 50bps rise in emerging market sovereign dollar bond spreads - result in a 0.7pps reduction in global GDP growth in 2017. World growth would slow to 2.1%, the weakest growth since the post financial crisis recovery began in 2010.
The benefits of higher wages on US consumer spending would be quite quickly offset by up-front rate hikes from the Fed. Fitch's simulations (which use the Oxford Economics' Global Macroeconomic Model) suggest the Fed would react by raising interest rates by an additional 150bps (relative to baseline) over the course of six months. In combination with the impact of higher wage costs and bond yields, this would see growth 1.4pps lower than baseline in the US in 2017, at 0.6%. About half the impact on US growth stems from the Fed's reaction and higher wage costs and half from higher bond yields.
The impacts outside the US would be smaller, but still significant. In the eurozone, Japan and the UK growth would be around 0.3pps weaker than baseline in 2017. Among emerging markets, growth is around 0.7pps weaker than baseline in China, Russia, Mexico and Turkey, but the effect would be smaller elsewhere. Most of the impact outside the US stems from the shock to bond yields.