‘Your pay is still - not - going up too fast’

The Economist posted a controversial article arguing that wages are driving inflation. Let’s revisit why this is not the case.

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The Economist published a piece on January 28, 2024 called “Your pay is still going up too fast” in the context of recent inflation dynamics. The problem – economics research has repeatedly shown that this is not the case. Pay and wages are not the cause of increasing inflation. 

The Wage-Inflation Spiral

The central point of The Economist piece boils down to the argument that higher wages cause a higher rate of inflation. We have covered this topic extensively on Nominal News – from an economic theory perspective, and have shown that wages have not caused or continued the inflationary surge observed in 2021 to 2023.  Empirical research has shown that wage increases have not caused inflationary spikes in the US. Quite the opposite – there is evidence that it is elevated inflation that causes wage increases.

The Economist piece, however, does not mention any research on this topic and continues to argue that wage growth needs to be brought down in order to tame inflation – or as they put it –

In order to get inflation under control, wage growth therefore had to come back down.

IMF Research of Similar Episodes

An IMF study looked at similar historical episodes to the one experienced in 2021. The main and unique characteristics of the inflationary episode that started in 2021 were:

• rising inflation;

• positive nominal wage growth;

• declining real wages; and

• declining unemployment.

The IMF researchers looked at multiple previous such macroeconomic situations (that is historical periods where all 4 bullet points were true at the same time) in the world and plotted the trajectory of four macroeconomic variables of each of the similar situations in the following chart:

Historically, there were 22 inflationary episodes similar to the one we just experienced. The charts above show how the four macroeconomic variables behaved after the start of the inflationary surge (quarter zero) relative to the values of these variables in quarter zero. To follow one such historic inflationary surge, let’s look at the red line, which represents the inflationary episode of the 1970s and 80s, famously ended by Federal Reserve Chairman Paul Volcker who raised interest rates to 20%. In that period, during 1979, in quarter zero (i.e. April-June, 1979) inflation was at 10.8% and it peaked in April 1980 at 14.4% (peaking 3 quarters after June 1979 and 4% higher than in quarter zero – April-June 1979) and fell to 6.4% around two years later in 1982. In the fourth chart, we can see that real wage growth fell in 1979 and 1980 and only started to increase in the latter part of 1980 (4 quarters after quarter zero), as inflation (in the top left chart) was decreasing.

Looking at the whole chart, the light blue area in each chart shows the outcome of the 4 variables for the middle 80% of similar historic inflationary episodes. The bottom right chart shows that real wage growth typically remained ‘elevated’ on average for 3 years, even after inflation fell, as the shaded area is above the 0% value. This happened because wages took time to catch up for the lost purchasing power. At the same time, in the top left chart, inflation does not re-accelerate as real wage growth is elevated. Nominal wage growth (bottom left), which is real wage growth plus inflation, follows a flat/slightly downward growth pattern since inflation is falling while real wage growth is slightly increasing.

Today’s Inflationary Surge

Today, we are about 2.5 to 3 years removed from the start of the inflationary surge in 2021. Nominal wage growth is at about 4.5%, 1.5% in real terms, over the last 12 months as of the beginning of 2024. Below is a chart made by the Economic Policy Institute of the recent nominal wage growth:

Nominal wage growth, which peaked at 5.9%, was approximately 0.5% above the Q4 2021 nominal wage growth. Given the IMF historical charts shown above, when looking at the dark blue line, nominal wage growth has a slightly downward trend after the period of inflation, closely following previous historical episodes seen in the bottom left chart (nominal wage growth today might even be on the lower end of comparable historical inflation episodes). Regarding real wage growth, People’s Policy Project reports the following data:

Similarly as nominal wage growth, real wage growth has also been following the historical trends over the course of the last 3 years. Real wage growth increased by 4-5 percentage points from their low in the fourth quarter of 2021, in line with past historical trends.

This real wage catch-up occurs because wages are most likely a lagging indicator of inflation – the reason wage growth is elevated is due to the inflation that already happened.

Falling Real Wages

The Economist piece also argues that to bring down the current rate of inflation, of around 3% for the past 12 months (although it has been less than that for the past 6 months), it is necessary for workers to take a pay cut. As they put it –

“That is because labour markets are not co-operating.”

The idea of bringing down wages to tame inflation is rooted in the theory that if we reduce the costs of labor in the production process, firms won’t have to increase prices as much, and thus the rate of inflation would fall. It is true that if real wages were to fall, the inflation rate would drop. That is one of the key ways increasing interest rates by central banks works to bring down inflation. With higher interest rates, businesses find it costlier to open and expand, reducing labor demand, increasing unemployment, reducing worker’s bargaining positions and thus resulting in lower wages.

The Economist describes the process as follows –

“Central bankers hoped that by raising interest rates they would cause demand for labour to fall—ideally cooling wage inflation without wrecking people’s livelihoods.”

The above statement is problematic because bringing down inflation caused by non-wage specific factors (the current inflationary surge was driven predominantly by supply shocks) by lowering real wages will, by definition, wreck people’s livelihoods. By forcing workers to have lower real wages, they will be worse off. Placing the entire onus of bringing down inflation on wages is a recipe for an unnecessary economic downturn.

Moreover, while real wage growth has recently been elevated, a few income groups have already taken a ‘pay cut’ – real wages have fallen for higher income individuals since the start of the pandemic. Average real wage growth over the period from March 2020 has just matched inflation, as average wages grew by 20% with prices also growing 20%. As noted above, a lot of current real wage growth is simply catch-up from the inflation we already experienced.

Productivity and Wage Indexation

The Economist makes two additional assertions in the piece that appear to be incorrect.

Productivity Growth

First – the Economist stated the following –

“Given weak productivity growth across the rich world (author note: we’re assuming this means developed economies), a 2% inflation target is probably achievable only if nominal wages grow by 3% a year or less.”

The Economist is implying that the long run productivity average is 1% (nominal wage growth of 3% is driven 2% by inflation and 1% by productivity). It is understating the long run average productivity which has actually been between 1.4% to 2.1%, thus wages can comfortably grow by 3.4% to 4% a year with 2% inflation.

However, productivity over the last 9 months of 2023 averaged almost 4%! So wages could have grown at 6-7% and it would still be in line with 2% inflation!

Wage Indexation

Second, the Economist mentions that inflation indexation of wages (when worker wages are adjusted each year at least by the rate of inflation) can make inflation more persistent. By definition, inflation-indexed wages cannot result in a higher inflation rate. Wages indexed only to inflation will actually reduce the inflation rate, if productivity is positive, which it typically is. That is because to maintain a fixed inflation rate, wages would need to go up by inflation + productivity growth, as discussed above.

Summary

The Economist piece appears to have repeated the old theory that wage growth causes inflation spirals. As discussed, empirical evidence shows this is not true. The Economist article did not cite any relevant academic research in its discussion to back this claim, relying on simply repeating the wage-inflation spiral theory. The main concern is that the article does not openly state this assumption and does not alert readers that this is just a theory. The article makes it seem like wage-inflation spirals are natural and occur often, when in reality, we haven’t really observed one in the US.

Focusing on wages in the inflation debate would only make sense if wage growth was significantly higher than the current observed rates. If nominal wage growth was well above 7-8% and not the current 4-5%, then there would be a reason to start talking about wages in the context of inflation. Until then, wages do not convey much meaningful information about where inflation is going that our standard inflation measures do not capture already.

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Interesting Reads from the Week

1. Article/News: As expected, the Personal Consumption Expenditure (PCE) index, a measure of inflation, for January came in ‘hot’. This was expected due to seasonality adjustments and the elevated implied housing costs. For the last 12 month, PCE is running at 2.8%.

2. Article:

   Claudia Sahm
   explains how the US economic policies of the last several years resulted in the US having one of the strongest economic performances of any country, as well as growth in wages for many workers.

3. Article:

   Sanuj Thomas
   describes how ‘textbook medicine’, which requires availability and access to many technologies, can struggle to be used in the real world, where many hospitals around the world have limited resources.

4. Article:

   Keshler Thibert
   gives a fascinating first hand account of Malta, its history and politics, along with interviews and photographs from the tiny island nation.

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Photo by Johannes Plenio.

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