Wages and Inflation

Inflation has skyrocketed globally in the last year. Besides commodities and energy, a lot of emphasis has been put on wages. To what extent do wages impact inflation?

Inflation Reduction

Inflation in the US typically is around 2% per year, as this is what the US Federal Reserve (the US Central Bank) targets. Since October 2021, inflation has significantly increased, recently peaking at around 8% on an annualized basis. Given that inflation is currently way above the 2% target, the Federal Reserve has undertaken an aggressive policy to bring down inflation since May 2022. This includes increasing the Federal Funds rate (the rate at which banks can lend to the Federal Reserve) at historically fast rates — from 0% to 3.75-4.00% in 7 months, with further interest rate increases expected.

One question that is being talked about is the impact of wages on inflation. Jerome Powell, the chairman of the Federal Reserve, said in May 2022 the following:

“Really the wages matter a fair amount for companies, particularly in the service sector. Wages are running high, the highest they’ve run in quite some time. And they are one good example of—or good illustration, really—of how tight the labor market really is, the fact that wages are running at the highest level in many decades. And that’s because of an imbalance between supply and demand and the labor market.

So we think, through our policies, through further healing in the labor market, higher rates, for example, of vacancy filling and things like that, and more people coming back in, we like to think that supply and demand will come back into balance and that, therefore, wage inflation will moderate to still high levels of wage increases, but ones that are more consistent with 2 percent inflation. That’s our expectation.”

This statement has been interpreted to mean that one of the main ways to successfully bring down inflation is to prevent wages from increasing too much, and that possibly even a reduction in wages is needed. In this post, I will dive into what economic research has so far shown on this question.

Impact of Wages on Inflation

The notion of wages influencing inflation, and in return inflation affecting wages, stems from what is called the wage-price spiral. A lot of early theoretical economic research has focused on this idea. This phenomenon was best described in a textbook by Layard, Nickell and Jackman (1994):

“[...] when buoyant demand reduces unemployment (at least relative to recent experienced levels), inflationary pressure develops. Firms start bidding against each other for labour, and workers feel more confident in pressing wage claims. If the inflationary pressure is too great, inflation starts spiraling upwards: higher wages lead to higher price rises, leading to still higher wage rises, and so on. This is the wage-price spiral.”

Another influential paper was Blanchard (1985). In this paper, Blanchard argued that in a setting where an increase in overall demand reduces unemployment, firms will have to compete for workers by offering higher wages, which will force them to increase their desired mark-up, pushing up prices of goods. With higher prices of goods, real wages of workers (i.e. the actual amount of goods workers can buy) fall, thus pushing them to demand higher wages. In a staggered negotiation situation, where these negotiations happen repeatedly (i.e. month-to-month) rather than in a world where wages and prices adjust immediately, inflation can persist for a long time.

Due to the simplicity and logical appeal of this theory, it has been heavily tested empirically. Most empirical studies to date suggest, however, that wages do not cause¹ inflation. Schwerzer and Hess (2000) from the Cleveland Federal Reserve did an overview of the economic research at the time and found very little evidence supporting the idea that wages cause inflation. Only one study showed a causal impact², while three others, and Schwerzer’s and Hess’ own work were not able to find this causality. The reason for the ambiguity in results is because inflation and wages move so closely together that attempting to separate and isolate which one causes which is not straightforward to do. Their own work focused solely on establishing the direction of causality, using what is called in economics and statistics “Granger causality”, which is a test whether the future values of one time series³ (inflation in our case) can be predicted by past values of another time series (nominal wage growth) and vice-versa. The review and analysis conducted by Schwerzer and Hess suggests that increasing wages do not cause inflation. On the contrary, evidence likely points to inflation driving increased wages.

Historical Inflation Spikes

Another way to tackle the question of whether higher wages cause inflation is to look at historical examples of whether this occurred during phases of higher inflation. John Bluedornet al., of the International Monetary Fund, identified 22 similar historical macroeconomic situations to the one currently occurring in the US (that is: price inflation was rising, wage growth was positive, but real wages and the unemployment rate were flat or falling⁴) and found that wage-price spirals did not develop in any of those instances. Inflation tended to drop in subsequent quarters after the initial inflation shock, with nominal wages⁵ slowly rising, resulting in increasing real wages. 

The following is taken from the IMF research: Chapter 2 of the October 2022 World Economic Outlook, “Wage Dynamics Post-COVID-19 and Wage-Price Spiral Risks.”

As can be seen above by following the blue line (median), inflation tends to start dropping from around 3 quarters, after the onset of similar macroeconomic situations as currently (the ones listed above). Based on most recent US inflation data, which started to fall in November 2022, it appears that a similar trajectory is being followed as in the previous cases.

Turning to other cases (with different macroeconomic conditions than the 22 cases identified above) where a wage-price spiral did occur, the inflation spiral lasted no longer than a year. Furthermore, real wage growth remained largely unchanged during those times. Thus, even if the wage-price spiral were to occur, it would most likely not last for a long time.

In the appendix, I elaborate on why wages are unlikely to impact inflation.

Conclusion

There is very little evidence that increasing wages leads to inflation. Furthermore, in instances where wage-price spirals did occur, the spirals themselves last for a very short time, at most a year. Current nominal wage increases are very far from levels needed for them to drive inflation. In the meantime, real wages have been consistently falling over this time period (the Dallas Federal Reserve estimated that on an annualized basis, real wages fell by 8.6% in the second quarter of 2022). Thus, focusing the discussion on wages right now will not address the issue of inflation.

However, I believe to deal with inflation, we should turn to ensuring inflation expectations (what everyone believes inflation will be in the future) are kept in check. In a future post, I will discuss the importance of inflation expectations on inflation growth and why the Federal Reserve and other Central Banks around the world responded or should respond aggressively to the current elevated inflation. 

Appendix: Labor Share of Income

Why is it that increasing wages are unlikely to lead to inflation? To understand the reason behind this, we can look at a standard production model used by nearly all of economic research. In the production model, a firm’s output depends on three factors: labor, capital, and a technology level. It is generally assumed by the Federal Reserve that technology improves by 1.5% a year. Thus, we produce 1.5% more goods and services per year, if the amount of labor and capital remain fixed. In a world with no inflation (or any price change), in order for us to consume the additional 1.5% production, we would need to be paid 1.5% more (anything that is produced must be consumed). As the Federal Reserve, however, targets a 2% inflation rate, that means that wages (i.e. the price paid for labor) can go up by 3.5% (1.5% for the extra consumption and 2% for the price inflation). This is also assuming that the price paid for capital (the return offered to the owners of machines, land, assets etc) also goes up by 3.5%.

However, it is not always the case that wages and the price of capital increase evenly. Thus, their relative proportion in production matters to compute inflation. This is referred to as the labor share of income - that is the proportion of income (income is price multiplied by output) that is given to labor against capital. In the US, the labor share of income has fallen from 65% in the 1940s to around 56-58% currently (the decline of the labor share is an important topic in economics as it is partially responsible for the rise in inequality). Therefore, as 56% of income goes to labor, in order to get an 8% inflation rate just from wages, nominal wages would need to go up by around 17% (56% x 17% = 9.5%, which is 8% plus the 1.5% technology improvement. Wages are nowhere near this level of growth. Based on data from the Atlanta Federal Reserve, nominal wages have gone up on an annualized basis by around 6.4% in August and September of 2022. Wages therefore only account for approximately 1.7% to 3.2% of the observed inflation (56% x 6.4% = 3.2% and removing between 0% to 1.5% for the technology improvement). Thus, most of the price inflation that we observe is driven by other factors - mainly the fact that certain goods are more expensive because of higher costs of imports, energy, and production. This was caused in large part due to the Coronavirus pandemic, which disrupted the optimal allocation of labor in many of the industries globally due to lockdowns. Labor in certain industries was unable to work, resulting in much costlier production. These higher production costs still persist today, for example in China, as it continues to have strict Covid lockdowns.

1. The emphasis here is on causality rather than correlation. Wages and inflation move together in the data — however, the question at hand here is are increasing wages the cause for higher inflation.

2. Schwerzer and Hess argue that this paper does not actually address the causality question, as the reverse, inflation causing wages, is not controlled for.

3. A time series is a sequence of data points in time order.

4. Wages growing below the inflation rate.

5. Nominal wages are measured in dollar terms, while real wages are measured in goods (what the wages can buy in terms of actual goods).