As we look forward to 2016 and think about what new issues could arise, one potential wild card is an acceleration of wage inflation.

The current debate around Federal Reserve’s policy centers on what the Fed will do with interest rates. Will they raise rates by 25 basis points in December or in March? Will they hike rates a few more times after that? Few in the markets seem to expect a more sustained rate increase or even the Fed’s own projected rate path, which has come to be known as the dot plots. However, there is one factor that could encourage the Fed to hike rates at a faster clip: a surge in wage inflation.

Wage inflation typically happens when unemployment is low and companies need to pay higher wages to attract qualified workers. To finance higher wages, companies must raise the prices of their goods and services or risk a decline in profitability. It is this dynamic that could lead to inflationary pressure.

During and after the global financial crisis in 2008, classical unemployment1, also known as U3, rose dramatically (Exhibit 1). It has been declining gradually in the last few years and finally hit 5%, which is low by historical standards and below long-term averages.

wage inflation wild card U.S. unemployment breakdown

The argument that there is still slack in the labor market centers on a broader unemployment measure, known as U6, which is a combination of Classical Unemployment (U3) and a few other measures of unemployment. One of these measures, which stands out for having risen dramatically during the crisis, is the measure of those employed part time for economic reasons (involuntary part-time workers), in other words people who are working part time because they can’t find full-time employment. The population of this group has also declined dramatically and is expected to reach a long-term average by early 2016 if it continues at its current pace (Exhibit 2).

wage inflation wild card involuntary part-time workers

So where does all this labor market healing leave us? We are in a good place in terms of people finding work, but in an uncertain place as it relates to wage inflation. Historically, when unemployment dipped below 5.5%, average hourly earnings (AHE) began to increase at a higher rate. You can see the wage inflation in the 2.5%-4% range when unemployment drops (Exhibit 3).

wage inflation wild card unemployment rate and wage growth

We recently entered a zone in which spikes in AHE are a matter of history—and we are beginning to see this development unfold in real time. Recent employment reports from the Bureau of Labor Statistics showed AHE increases of 2.3% – 2.5%. The bureau’s third-quarter Productivity and Costs report also showed significant increases in hourly compensation. If these trends continue, we could see the Fed surprising us with a faster pace of rate hikes.

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1 Classical unemployment occurs when real wages are kept above the market clearing wage rate, leading to a surplus of labour supplied. Classical unemployment is sometimes known as real wage unemployment because it refers to real wages being too high.