This Selected Issues paper on the United States analyzes the measures of potential output, natural rate of unemployment, and capacity utilization. Traditionally, measures of resource utilization have been used as indicators for the potential build-up of inflation pressures, and hence as guides for the formulation of macroeconomic policy. The paper highlights that the most commonly used indicators of resource utilization in the United States are the output gap, the employment gap, and capacity utilization in industry. The paper also analyzes the wage and price determination and productivity trends in the United States.

Abstract

This Selected Issues paper on the United States analyzes the measures of potential output, natural rate of unemployment, and capacity utilization. Traditionally, measures of resource utilization have been used as indicators for the potential build-up of inflation pressures, and hence as guides for the formulation of macroeconomic policy. The paper highlights that the most commonly used indicators of resource utilization in the United States are the output gap, the employment gap, and capacity utilization in industry. The paper also analyzes the wage and price determination and productivity trends in the United States.

II. Wage and Price Determination1

1. Since the second half of 1996, consumer price inflation in the United States has slowed noticeably. At the same time, growth in real output has accelerated, and the unemployment rate has declined to historically low levels. The confluence of these developments has raised a number of questions about how strong growth in output and employment can coexist without igniting stronger upward pressure on consumer prices. Analysis presented here suggests that, while there have been no fundamental changes in the way in which wages have been determined over the course of the current business cycle, the significant reduction in the rate of increase in nonwage labor compensation since 1995 has played an important role in restraining consumer price inflation. Other factors, such as declines in import prices, have also played a role. The acceleration in real-wage growth that has occurred since 1995 has resulted from slower consumer price inflation and faster growth in labor productivity.

A. Behavior of Labor Costs over the Business Cycle

2. One important factor driving the slowdown in price inflation since 1996 has been the behavior of labor costs over the current business cycle.2 In particular, Figure 1 shows that growth in wages and salaries, as measured by the Employment Cost Index (ECI), was tempered during the initial phases of the current expansion in 1992, relative to the initial phases of the previous expansion. Since the last quarter of 1996, growth in wages and salaries has picked up, and it now more closely resembles the pattern exhibited over the previous cycle, although recent growth rates are still slower than in the previous cycle.

Figure 1.
Figure 1.

United States: Wage and Salary Component of the Employment Cost Index (ECI)

(Percentage change over the previous four quarters)

Citation: IMF Staff Country Reports 1999, 101; 10.5089/9781451839579.002.A002

Sources: IMF staff estimates; and Bureau of Labor Statistics.

3. Real wages and salaries (as measured by nominal changes in the wage and salary component of the ECI less inflation) have exhibited strong growth in the current cycle relative to the previous one (Figure 2). Since the latter part of 1996, actual real compensation has exceeded expected compensation (nominal changes in the wage and salary component of the ECI less expected inflation) as a result of the fact that actual inflation was less than anticipated inflation. This stronger-than-expected growth in real wages may have served to temper demands for larger nominal wage increases since 1996. Also, workers may have agreed to accept smaller nominal wage increases in return for enhanced job security, but Kramer (1997) found no strong econometric support for this hypothesis.

Figure 2.
Figure 2.

United States: Real Employment and Real Wages

Citation: IMF Staff Country Reports 1999, 101; 10.5089/9781451839579.002.A002

Sources: IMF staff estimates; Bureau of Labor Statistics; and Livingston Survey.

4. To assess whether there has been a fundamental change in the way in which wages and salaries are determined over the current business cycle, a wage Phillips curve was estimated over the period from 1983Q2 to 1995Q4. In this equation, changes in the wage and salary component of the ECI were regressed on lagged consumer price inflation and the level of the unemployment gap, defined as the NAIRU less the actual rate of unemployment (Table 1). 3 Using the estimated equation, an out-of-sample forecast was generated for the period 1996Q1 to 1998Q4 and the results were compared to the actual changes over the specified period (Figure 3). In general, the estimated wage Phillips curve predicts actual wage inflation fairly well, but the equation tends to underpredict actual wage inflation somewhat over the period between 1997Q2 and 1998Q4. Over this period, the unemploy-ment gap was rising, which would suggest higher wage inflation; however, this effect was offset by the decline in consumer price inflation, proxying inflation expectations.

Table 1.

United States: Estimate of a Wage Phillips Curve 1/

(1983Q2–1995Q4)

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Wage inflation is defined to be the four-quarter rate of increase in the Employment Cost Index for wages and salaries. The unemployment gap is defined as the staff’s estimated natural rate of unemployment less the civilian unemployment rate. The annual data for the natural rate were interpolated to quarterly frequency.

The Theil inequality coefficient is defined as the square root of the sum of the differences between the actual change in the dependent variable and the change in the predicted value of the dependent variable divided by the sum of the actual change in the dependent variable. If this coefficient is zero, then the forecast is “perfect.” The closer the Theil coefficient is to zero, the better the forecast.

Figure 3.
Figure 3.

United States: Actual and Projected Wage Inflation

(Percentage change over the previous four quarters)

Citation: IMF Staff Country Reports 1999, 101; 10.5089/9781451839579.002.A002

Source: IMF staff estimates.

5. While nominal wages and salaries, as measured by the ECI, have behaved in a similar fashion over the current cycle, relative to the previous cycle, growth in overall labor costs has been much slower over the current cycle as a consequence of the sharp slowdown in the growth in nonwage costs (benefits) and faster productivity growth. As shown in Figure 4, the benefit component of the ECI has increased at a substantially slower rate since 1995, compared to the same period of the previous business cycle. This slowdown is mainly attributable to smaller rates of increase in expenditures by employers on health insurance benefits (Table 2), workers’ compensation, state unemployment insurance costs, and lower costs of funding employee pensions. 4 Growth in labor productivity (Figure 5) has quickened since 1995, compared to the same period of the previous cycle, owing to the effects of strong capital investment and faster technological progress. This acceleration in labor productivity growth has also contributed to restraining the growth in unit labor costs.

Figure 4.
Figure 4.

United States: Benefit Component of the Employment Cost Index

(Percentage change over the previous four quarters)

Citation: IMF Staff Country Reports 1999, 101; 10.5089/9781451839579.002.A002

Sources: IMF staff estimates; and Bureau of Labor Statistics.
Figure 5.
Figure 5.

United States: Productivity and Unit Labor Costs

Citation: IMF Staff Country Reports 1999, 101; 10.5089/9781451839579.002.A002

Sources: IMF staff estimates; and Bureau of Labor Statistics.
Table 2.

United States: Employer Costs per Hour Worked For Health Insurance, Private Industry, from the Employment Cost Index

(In percent change from previous year)

article image
Source: U.S. Department of Labor, Bureau of Labor Statistics (1998), unpublished estimates.

6. As a result of these factors, labor’s share in national income has declined quite sharply relative to the previous cycle (Figure 6), and business profitability (as measured by capital’s share in national income), has increased. After reaching a peak of more than 74 percent six quarters into the current cycle, labor’s share in national income has declined to about 71 percent. This behavior is somewhat uncharacteristic, as the average value of labor’s share in national income over the course of the current cycle has fallen below the average value of labor’s share in the five previous business cycles. 5 Slower growth in labor costs, as reflected in a declining share of labor income, have contributed to significant restraint on consumer price increases since 1996.

Figure 6.
Figure 6.

United States: Labor’s Share in the Corporate Sector 1/

Citation: IMF Staff Country Reports 1999, 101; 10.5089/9781451839579.002.A002

Sources: IMF staff estimates; and Bureau of Economic Analysis.1/ Labor’s share is defined as total renumeration to labor expressed as a percent of the value of output in the corporate sector.

B. Model of Consumer Price Inflation

7. One striking development during the current expansion has been the steady decline in labor’s share of national income which may suggest that lower labor costs have been a factor in restraining consumer price inflation, in the context of a model where prices are set as a markup over marginal costs of production. To assess this hypothesis, an indicator of real marginal cost is needed because marginal cost is not directly observable. Under the assumption that the aggregate production function exhibits constant returns to scale, if all inputs are increased by the same proportion, output will increase by the same proportion. As a result of this structure, total costs of production equal the cost of producing one unit of output multiplied by the level of output—that is, total cost is just the cost of producing one unit “scaled up” by the level of output. Consequently, total cost is simply a linear function of the level of output, so marginal cost and average cost are both constant and equal to each other. Under the additional assumption that labor is the only variable input, the marginal cost of production, which equals average cost, is just labor costs (the wage rate multiplied by the level of employment) divided by the level of output. Real marginal costs are obtained by dividing this fraction by the output price, so real marginal costs can be represented by labor’s share—labor cost divided by the value of output. Gali and Gertler (1998) and Rotemberg and Woodford (1999) emphasize the importance of including a variable that measures real marginal costs of production in traditional price Phillips-curve equations because measures of the output gap and the unemployment gap are unreliable, since estimates of both potential output and the NAIRU are not observable and subject to significant error.6

8. To explore the role that declining labor costs and import prices may have played in restraining consumer price inflation, an augmented price Phillips curve was estimated that adds labor’s share in national income and the change in import prices as explanatory variables. The labor share variable was included because it captures the changes in labor costs, including the slower rate of growth in benefit compensation, and the important acceleration in labor productivity that has taken place over the current business cycle. In contrast to unit labor costs, which typically measure costs only in the manufacturing sector, labor’s share in the corporate sector is a broader measure of labor costs in the economy.7 The change in import prices was included to capture the effects of external factors in restraining inflation.

9. The results (Table 3) show that the coefficients on the lagged consumer price term and the unemployment gap have the expected signs and are statistically significant. The magnitudes of these coefficients also are broadly similar to those obtained in the studies by Hogan (1998) and Staiger, Stock, and Watson (1996). 8 Import prices and the labor share variables also enter the consumer price Phillips curve with the expected signs. Overall, the estimated Phillips curve generally overpredicts actual inflation (except for a short period in early 1997 (Figure 7)). In explaining the inflation forecast, lagged inflation was the most important variable, followed by changes in import prices, which restrained consumer price inflation as a result of reductions in the prices of basic commodities and the appreciation of the U.S. dollar. Finally, the decline in labor costs, reflected in labor’s share, 9 was the third most important variable, while the unemployment gap contributed the least.10

Table 3.

United States: Estimate of a Price Phillips Curve 1/

(1975Q2–1998Q4)

article image

Core inflation is defined as the four-quarter rate of change in the core CPI (the CPI excluding food and energy). the unemployment gap is defined as the staff’s estimated natural rate of unemployment less the civilian unemployment rate. The annual data for the natural rate of unemployment were interpolated to quarterly frequency. The change in the labor share variable is defined as the four-quarter rate of change in the ratio of total labor costs to the value of output in the corporate sector.

The Theil inequality coefficient is defined as the square root of the sum of the differences between the actual change in the dependent variable and the change in the predicted value of the dependent variable divided by the sum of the actual change in the dependent variable. If this coefficient is zero, then the forecast is “perfect”. The closer the Theil coefficient is to zero, the better the forecast.

Figure 7.
Figure 7.

United States: Actual and Projected Inflation

(Percentage change over the previous four quarters)

Citation: IMF Staff Country Reports 1999, 101; 10.5089/9781451839579.002.A002

Source: IMF staff estimates.

10. The inflation forecast derived from the Phillips curve used here outperforms the inflation forecast derived from a traditional Phillips-curve specification that includes only lagged inflation and the unemployment gap as explanatory variables, as well as the inflation forecast derived from a traditional specification augmented with a variable measuring the change in import prices. More specifically, using the traditional Phillips-curve specification, the root mean-square error (RMSE) is 0.29 and the Theil inequality coefficient (TIC) 0.06, while in the case of the traditional Phillips curve augmented with the change in import prices, the RMSE is 0,21 and the TIC is 0.04. For the Phillips curve used in this paper, the RMSE of 0.17 and the TIC of 0.03 are below the corresponding values of these indicators in the other two specifications.

List of References

  • Gali, Jordi, and Gertler Mark, 1998, “Inflation Dynamics: A Structural Econometric Analysis.

  • Hogan, Vincent, 1998, “Explaining the Recent Behavior of Inflation and UnemploymentInternational Monetary Fund, SM/98/188.

  • Kramer, Charles, 1997, “Job Uncertainty and the Phillips Curve,” International Monetary Fund, SM/97/186.

  • Lipschitz, Leslie, and McDonald Donough, 1991, “Real Exchange Rates and Competitiveness: A Clarification of Concepts and Some Measurements for Europe,” International Monetary Fund, Working Paper No. 91/25.

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  • Rotemberg, Julio, and Woodford Michael, 1999, “The Cyclical Behavior of Prices and Costs,” Cambridge: National Bureau of Economic Research, Working Paper No. 6909,

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  • Staiger, Douglas, Stock James, and Watson Mark, 1996, “How Precise are Estimates of the Natural Rate of Unemployment?National Bureau of Economic Research Working Paper 5477, March.

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  • U.S. Department of Labor, 1998, “Employment Cost Indexes,Bureau of Labor Statistics, Bulletin No. 2504.

1

Prepared by Stephen Tokarick, Jorge Chan-Lau, and Gustavo Ramirez.

2

The current business cycle is defined to be the period from March 1991 to the present, while the previous business cycle is taken to be the period from November 1982 through July 1990. These business cycle dates are taken from definitions adopted by the National Bureau of Economic Research (NBER), The beginning date of each cycle refers to the trough of the cycle. The figures used in the paper depict the behavior of each labor-market indicator six quarters prior to the trough of the cycle and 32 quarters after the trough.

3

This specification follows the work of Kramer (1997).

4

See U.S. Department of Labor (1998). Data on health insurance costs were obtained from unpublished estimates of the Bureau of Labor Statistics.

5

The last five business cycles and the average value of labor’s share over the cycle was: November 1970 to November 1973 (74.2); March 1975 to January 1980 (73.1); July 1980 to July 1981 (73.7); November 1982 to July 1990 (72.5); and the current cycle (71.7).

6

Lipschitz and McDonald (1991) propose, in a different context, that comparing labor shares in value added across trading partners yields useful information about price competitiveness. They propose using a profit-based indicator of competitiveness based on real unit labor costs, i.e., labor’s share in valued added.

7

Hogan (1998) found that adding the change in real unit labor costs to a standard Phillipscurve equation did not improve the predictive power of the equation.

8

For example, on the unemployment gap variable, Hogan (1998) obtains a coefficient of about 0.26 and Staiger, Stock, and Watson (1996) obtain a coefficient between 0.22 and 0.41, depending on the specification.

9

Gali and Gertler (1998) also find that a decline in real marginal costs of production, as exhibited by a decline in labor’s share, has a significant impact on inflation.

10

On average, lagged inflation accounted for 104 percent of forecast inflation, the change in import prices accounted for -8 percent, the change in the labor share accounted for 1.9 percent, and the unemployment gap accounted for 1.7 percent.

United States: Selected Issues
Author: International Monetary Fund
  • View in gallery

    United States: Wage and Salary Component of the Employment Cost Index (ECI)

    (Percentage change over the previous four quarters)

  • View in gallery

    United States: Real Employment and Real Wages

  • View in gallery

    United States: Actual and Projected Wage Inflation

    (Percentage change over the previous four quarters)

  • View in gallery

    United States: Benefit Component of the Employment Cost Index

    (Percentage change over the previous four quarters)

  • View in gallery

    United States: Productivity and Unit Labor Costs

  • View in gallery

    United States: Labor’s Share in the Corporate Sector 1/

  • View in gallery

    United States: Actual and Projected Inflation

    (Percentage change over the previous four quarters)