Is the expansion in US labor supply pulling down wages?
By: Ernie Tedeschi
Tags: Economics, Labor Market, Wages, Employment, Monetary Policy

The robust US recovery has expanded prime-age employment and broadened the labor supply. But wage growth in recent months has stopped accelerating across different measures. I show that the plateauing in prime-age wage growth is not due to direct compositional effects, but due to softer rises among the continuously-employed. In fact, while compositional effects on prime-age wages are generally negative, they have been somewhat less so in the last few years. But this does not rule out other ways in which shifts in employment or the labor supply may be weighing down on wages.

More than a decade after the official end of the Great Recession, the US labor market is still expanding.

Employment among Americans 25–54 years old — “prime-age” workers — has risen by about 665,000 over the last year.[1] That’s a healthy clip, far higher than the 257,000 necessary to keep prime-age employment on pace with population growth.

What’s more, as employment rises, nonemployment is falling fastest among the ranks of Americans long thought to be the least-attached to the labor force. That 665,000 rise in prime-age employment was associated 1:1 with a 665,000 fall in nonemployment, of which 205,000 came from the disabled[2], representing almost a third of the nonemployment fall.[3]

The continued good news on the labor market seems at first glance to stand in stark contrast with recent wage developments. Average hourly earnings for all private nonfarm workers (regardless of age) over the last three months were 3.1% higher than a year earlier. That’s a passable outcome but actually slower than in the recent past; just last August wage growth was a bit higher at 3.4%. This weakening acceleration in wage growth in the face of above-trend labor supply growth, coupled with the lack of inflation pressure, is strong evidence that the US is not at full employment yet.

One possibility is that these two phenomena are in fact directly related: that at this late stage in the recovery, new workers are coming into the types of jobs that pay below-average wages, and in doing so they pull down the overall average, depressing wage growth. Economists call these compositional effects.

Notice how compositional effects might give a skewed read of labor market health. An economy that brings in low-wage or marginally-attached workers is likely one that is doing well and has strong momentum. But these very workers might lower the measured average wage and make the labor market look a bit worse on its face.

Compositional effects are a real issue to be aware of in labor market data. But a problem with blaming them for the most recent wage sogginess is that alternative measures of wage growth that adjust for compositional effects — such as the Atlanta Fed Wage Growth Tracker and the Employment Cost Index— have also slowed down.

We can see this too for prime-age workers specifically. The Current Population Survey (CPS) allows us to hone in on wages by age group. I decompose the 12-month growth in average wages for prime-age workers into two effects: wage growth among those who were continuously-employed over the year on the one hand, and the drag or boost that came from inflows into and outflows from employment (that is, compositional effects) on the other. [4]

The summary results below show that the recent deacceleration in wage growth appears to be driven not by new workers pulling down the average, but by existing workers seeing slower raises. In fact, while ongoing compositional wage effects remain negative, they have been gradually shrinking over the last seven years.

Moreover, I can go a step further and break down these ongoing compositional effects by nonemployment reason: that is, the net effect on wages from job finders from a nonemployment margin and job leavers into that same margin. The chart below takes the employment inflow/outflow effect shown above and decomposes it by these nonemployment margins.

What this shows is first that disability flows typically exert positive pressure on prime-age wage growth. That’s because while both workers who leave employment for disability and workers who find jobs out of disability tend to make below-average wages, the job finders tend to make higher wages than the job leavers did, creating a positive swap for wage growth.

More broadly, the softer ongoing compositional effects on wage growth appear to be due largely to evaporating pressure from the long-term unemployed. This makes sense: I’ve defined each of these nonemployment effects to be net of both flows into and out of employment. But unique among these categories, the net flow effect from the long-term unemployed is almost entirely from job finders, since virtually all job leavers who go into unemployment become short-term unemployed by definition.[5] So as the number of long-term unemployed Americans keeps falling, there are fewer and fewer job finders from their ranks — again, by definition — and therefore they exert smaller and smaller downward wage pressure.

But all of this doesn’t mean there still aren’t direct or indirect compositional effects on wages. As more and more marginally-attached workers find jobs, they will gradually shift the population of continuously-employed workers over time, which may affect that component of wage growth. However, the Employment Cost Index shown earlier ought to control for many of these effects as well, and it too is showing signs of slow down, though it is calculated from a survey with a smaller sample size than the CPS or the payroll survey.

There may also be a labor supply effect on wages where, as nonparticipants rejoin the labor force, there is less pressure on firms to raise wages. Wages could therefore only rise in fits and starts as labor supply expansions have a dampening effect on wage growth.

But in the meantime, to the extent job finders and leavers are affecting average wages, it appears to be a somewhat lower drag than normal. The recent wage deceleration therefore is likely driven by something else.