What higher U.S. wages meanJanuary 8, 2013: 12:32 PM ET
Want to know where the economy's headed? Watch for wage inflation.
FORTUNE -- Just as most U.S. workers see less in their paychecks, a slowly improving job market is boosting wages. Earnings have generally been flat for the past few years, and the uptick couldn't have come at a more sensible time. For the second month in a row, hourly earnings on average rose 0.3% in December – the biggest consecutive increase since the economic recovery began in mid-2009.
But while this might be good news for workers, it could very well make more complicated the Federal Reserve's job to keep prices stable. And unnerve bond investors plenty more.
At the start of the year, Congress ended a break on the payroll tax as part of a deal to avert the fiscal cliff. Which means workers will pay a higher tax rate of 6.2% -- up from 4.2% -- that will help pay for Social Security benefits. For instance, those earning $50,000 and paid twice a month would see $41.67 less in each paycheck. Wages have edged up, though. December's rise brings the average weekly paycheck to $818.69, up 1.2% from October.
The question is will wage inflation move upward from here? Judging by recoveries of the recent past, it's at least a possibility, says Jim Paulsen, chief investment strategist at Wells Capital Management. In a research note last week, he says that blaming the severity of the latest recession for why we haven't seen wages rise rapidly is wrong.
Wages do rise as the economy recovers from recession, just not right away. Prior to 1980, wages shot up almost immediately at the start of recoveries following recessions. The trend has changed in the past 30 years, however. Recoveries aren't as strong as they used to be. It has taken longer, years even, before wages steadily rise as the economy heals.
Contrary to what others might think, Paulsen argues that the weaker recovery has less to do with households struggling to shed debts racked up amid the housing boom or saving more. Rather, more workers are leaving the labor force as they age.
"If wages continue to respond as they have in the last 30 years, labor inflation could soon begin a more sustainable rise," Paulsen writes.
He takes a look back: When the economy was recovering following the downturn in the early 1980s, the rate of annual wage inflation didn't steadily rise until four years in. It panned out similarly in 1990. And after the end of the 2000 recession, it took nearly three years for wages to rise.
In this recovery, wage inflation steadily declined for the first three and a half years.
If wages continue rising as they have during the past two months, it would be a plus for workers. It could also complicate a few things.
When workers get bigger paychecks, the costs for most everything else goes up because giving employees a raise also means the employer must increase the price they charge for whatever goods or services they sell to maintain corporate profits. This deflates the good news that comes with a raise. It also leads wages to rise again and so on.
More broadly, wage inflation could certainly pressure the Fed to change its plans and start raising interest rates earlier than expected. In December, the central bank announced it planned to hold short-term interest rates near zero at least until the unemployment rate fell below 6.5% so long as inflation remained under control. The hope is that low interest rates would get households and businesses to borrow cheaply and spend more, thereby boosting economic growth.
Officials noted inflation remained low; they don't expect it to be a problem. Already, though, some are debating how soon to stop the Fed's plans.
And if rates rise, that means the price on bonds fall. For bond investors, that could be bad news. "I am suspect of the bond market this year," Paulsen says. In a note, he forecasts stocks stand to gain in 2013 at the expense of bonds.
Rising confidence will likely drive the Standard and Poor 500 (SPX) above its previous all-time high of 1565 and possibly even as high as 1700 sometime this year. This will be driven less by earnings and more by improving confidence of investors as they watch the economy improve, he predicts.
So this year, watch where wages go. It will say a lot about the pocketbooks of consumers. As well as investors.