Wage Growth Is Coming. Those Profits Can't Last.

(Bloomberg View) -- One of the big economic questions for 2018 is whether the strong economic expansion and the resolution of tax uncertainty kick the labor market and wage growth into a higher gear. It might take months for decisions made by corporations and workers to show up in the economic data. We'll get some clues on what companies are thinking with earnings season underway and set to pick up this week. Already, though, the Beige Book, published by the Fed on Wednesday, revealed some clues on labor market dynamics and employer psychology that point to a pickup in wage growth and inflation in the months to come.

The Beige Book is a report published by the Fed eight times a year with a summary of economic conditions in each of the Fed's 12 districts. It's full of anecdotes and thoughts on aspects of the economy in the various districts, and can shine a light on emerging trends that bear watching. As I like to say, the plural of anecdote is data.

Most of the districts mentioned seeing tight or tightening labor markets, but there were two anecdotes in particular that may help crack the puzzle on how labor markets could be so tight without a full-fledged breakout in wage growth. When an employer in the Boston district was asked why the company didn't raise wages as a way of attracting more workers, it responded that if it had done so, it would have had to pay all the existing workers more, which would be uneconomic. And another contact in the Boston district said that when a worker departs, the replacement typically ends up earning 10 percent more than the departing worker made.

This shows a difference between market wages -- what it takes to land a new hire -- and average wages -- what people employed currently make. That disparity should be a red flag for investors, as it indicates the current level of corporate profitability may be unsustainable. If replacing workers who quit requires giving out big raises to the existing workforce, and if new hires need to be paid a lot more than the recently departed, your workforce is underpaid. If all your employees quit tomorrow, it'd cost you a lot more to replace them than you're currently paying. In a lot of industries, the only way for workers to get a big raise is to quit, because employers have a bias against giving windfall raises -- for cultural or psychological reasons. (For one thing, employers can count on inertia to keep many underpaid workers in place indefinitely.)

In a normal labor market, the difference between market wages and average wages shouldn't be that much. But the current environment isn't normal. The unemployment rate, at 4.1 percent, is at its lowest level in 17 years. The labor market is tight enough that at least one employer in Wisconsin has workers on staff who are active prisoners and making a market wage -- $14 an hour. Yet at the same time, many employers, accustomed to a generation-long bout of disinflation and generally loose labor markets, are reluctant to pay up to attract the workers they say they need. Additionally, many workers have scars from the great recession and bouts of being unemployed or underemployed, and perhaps aren't as eager to test the labor market waters as they were in the booming 1990s. All the while, economists and policymakers look at the slow wage-growth and inflation data and assume we haven't broken out of our doldrums.

But this isn't going to last much longer. Roughly 3 million people quit their jobs every month, around 2.2 percent of all workers. A company can survive for a while by leaving vacancies unfilled and saddling remaining employees with the work. But eventually key positions open up that absolutely must be filled, and staffing has to be maintained to ensure an adequate level of service. When that time comes, the companies who have been most focused on keeping labor costs low, and have shown industry-leading profit margins to investors, may be in for the most pain, through some combination of customer complaints, unfilled orders and being forced to pay "surge pricing" to attract workers immediately.

The stock market is euphoric as investors anticipate lower tax rates flowing through to the bottom line, but this looming wage shock poses a big risk to profits and equities in 2018.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Conor Sen is a Bloomberg View columnist. He is a portfolio manager for New River Investments in Atlanta and has been a contributor to the Atlantic and Business Insider.

To contact the author of this story: Conor Sen at csen9@bloomberg.net.

To contact the editor responsible for this story: Philip Gray at philipgray@bloomberg.net.

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