Wages are rising but not inflationary
The Federal Reserve continues to believe that wage growth in the US is too high and contributing to inflation, according to Fed chair Jerome Powell.
The Employment Cost Index (ECI), the most commonly watched measure of labor costs to employers, rose 4.3 percent last quarter and 4.4 percent over the last two. Assuming productivity growth at its recent trend (1.4 percent annually), these data suggest that labor costs are rising by 3% – above the Fed’s target of 2% but consistent with a moderately higher target advocated by economists like Paul Krugman and Olivier Blanchard.
Yet a closer look at the data over the last 3 months suggests that wage growth might be fairly consistent with the Fed’s 2% target. For a different measure of wage growth – average hourly wages – has been rising by just 3.2 percent over the past 3 months. These data indicate the ongoing softening of the labor market, induced by two years of rising interest rates, is indeed reducing wage growth.
But why do the two measures of wage growth diverge? The ECI differs from average hourly wages for two reasons: 1) It captures benefit costs as well as wages and salaries; and 2) It holds occupations and industries in the labor market constant, and thus measures cost increases holding the structure of the labor market constant. But, in the ECI, benefit growth has recently been lower than wage growth; so the shift of employment growth towards lower-wage occupations and industries must be causing the two measures to differ.
Apparently, high recent employment growth in industries like leisure and hospitality and in lower-wage jobs in health and elder care are moderating the overall costs of labor in the US economy. And the retirements of high-wage Baby Boomers, and their replacement by younger and cheaper workers, likely reinforces this shift towards lower-wage work categories. If true, the average wage measure might give us a more accurate picture of the true labor costs employers face.
And there is another factor which makes this level of wage growth look reasonable: our recently high rate of productivity growth.
Productivity growth enables wages to rise without causing inflation. For example, 2% inflation is consistent with 4% wage growth if productivity growth is also 2%, allowing for real wage growth (i.e., wage growth above inflation) of 2% as well.
Unfortunately, measured productivity growth has been very volatile since the pandemic. Large layoffs during the pandemic caused productivity to briefly skyrocket, and strong employment recovery since the pandemic has created many quarters with negative growth since then. Indeed, productivity growth declined by about 5% in the first half of 2022, as employment strongly rebounded while output growth was fairly flat. On the other hand, it has averaged over 4% in the past two quarters.
Also, productivity growth is notoriously difficult to measure, and our estimates are often biased downward. To take one well-known example, when statins successfully reduce cholesterol and heart attacks, as well as medical procedures to deal with them, this reduces measured GDP and productivity growth – though we are all better off because of it.
Still, combining all quarters since the beginning of the pandemic in 2020, measured productivity growth has averaged 1.6%. And, in the past four quarters, it has averaged 2.3%. It does not seem outrageous to suggest that productivity growth right now is above its recent trend of 1.4%, and is likely closer to 2%. And, as adoption of artificial intelligence (AI) in American businesses grows, productivity growth will no doubt increase as well.
Overall, It looks like wages and labor costs are now growing at an annual rate of about 4% or less while productivity is growing about 2%, in which case workers can enjoy 2% real wage growth per year while its contribution to inflation is also 2%.
The Fed’s current pause in interest rate growth should continue, as we carefully monitor ongoing labor market trends. But, after a number of decades in which wage growth was fairly stagnant, the bump-up in worker wages that began after the pandemic (during the “Great Resignation”) is welcome in its currently muted form and should be allowed to continue.
