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Strong wage growth is usually a good thing for workers and a boon for the economy.
right Now? Not much.
Average wage increases are near the highest level in decades, fueling inflation, says the Federal Reserve. This could force Fed officials to raise interest rates more next year, which could push the US into a mild recession.
Economists say moderating wage growth is key to avoiding deflation.
But it may not be that simple.
What is the average wage increase in 2022?
Average annual wage gains fell to 5.2% in the third quarter from 5.7% early this year, according to the Labor Department’s Employment Cost Index. But this is still well above the average of 3.3% before the pandemic and about 2% in the decade before the health crisis.
Strong pay increases are usually a good thing. Since the COVID crisis, they have not kept up nearly as much with inflation, which means consumers are losing purchasing power.
But a sharp rise in wage growth contributes to inflation because employers with high labor costs usually raise prices to preserve profits.
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Meanwhile, the Federal Reserve sharply raised interest rates to lower annual inflation, which hit 9.1% in June before falling to 7.1% in December.
The Fed raised its main rate by more than 4 percentage points in 2022, the highest rate since the early 1980s, and expects another three-quarters point increase next year to about 5.1%. This is the level many economists say will tip the nation into recession.
Fed Chairman Jerome Powell said the Fed will continue to raise interest rates until wage growth is contained.
Why are wages rising so quickly?
Inflation, especially in service industries like restaurants and healthcare, has remained high as consumers have shifted their purchases to activities like eating out and travel now that the pandemic has abated. This has led to an increase in the demand for workers in those sectors and an increase in wages. Powell said price increases in those industries make up more than half of the core core inflation measure and are mostly driven by wage increases.
Underemployment continues in those sectors because millions of Americans have quit during the coronavirus health crisis or retired early. Not many are expected to return. So employers must raise wages to draw from a smaller pool of job candidates or lure back those who have left.
“Wages are increasing … well above what is consistent with the 2% inflation rate (the Fed’s target),” Powell said at a news conference this month. “We have ways to go there.”
He added, “The labor market remains unbalanced, as demand greatly exceeds the supply of available labour.”
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What actually happens when the Federal Reserve raises interest rates?
Traditionally, the Federal Reserve raises interest rates to increase borrowing costs, weaken the economy and make hiring and investment more expensive for businesses. Increases in the unemployment rate usually lead to smaller increases in wages and vice versa.
This relationship between unemployment and wage growth – known as the Phillips curve – has eroded in recent decades, says Jonathan Millar, chief US economist at Barclays.
In the decade after the Great Depression, unemployment fell sharply while wages increased modestly. This is largely because the Americans were expecting weak inflation for various reasons and did not ask for large increases.
As a result, Millar says, nearly every percentage point increase in the unemployment rate results in only a quarter of a point decrease in wage growth. So, he says, it would take an 8 percentage point increase in unemployment to shrink wage gains by 2 percentage points to 3% to 3.5%. Such a scenario means a severe recession.
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Another factor that could keep wage growth up, Millar says, is that jobs fell from a record high of 11.5 million a year ago to 10.3 million in October, but that’s still well above the pre-COVID level of 7 million.
Although job growth is expected to slow as the economy loses steam next year, employers will still have to offer healthy raises to attract workers because there are fewer of them, Millar says.
Is the US inflation rate going down?
Mark Zandi, chief economist at Moody’s Analytics, is more optimistic. He does not believe that wage growth has been pushed higher during the pandemic by a shortage of workers but by higher inflation expectations.
Record gasoline prices, supply chain problems and Russia’s war in Ukraine have sent consumer prices soaring, prompting workers to demand bigger increases.
Now, however, pump prices have fallen sharply and supply hurdles have improved, dampening consumer inflation expectations for the next 12 months, According to recent opinion polls.
“It should lead to lower wage growth,” Zandi said.
He expects annual wage increases to decline to 4% by the end of 2023 and 3.5% by mid-2024, Persuading the Fed to back off interest rate hikes as the direction clears early next year.
And that, he says, should help the economy avoid a recession.
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