The jumps in the inflation rate over the last few months have been larger and longer-lasting than expected.  For much of 2022 economic forecasters, including those at the Federal Reserve, assumed that higher inflation rates would be short-lived—or “transitory” using the preferred jargon of the day. Inflation was expected to start shifting back towards the Fed’s 2% target as supply-chain bottlenecks were resolved and a pandemic-induced shift in demand for consumer goods swung back toward consumer services.  Instead, recent inflation prints have set 40-year records and we are seeing more discussion about the possibility of a “wage-price” spiral. 

In this data commentary, we examine the factors which can lead to a wage-price spiral and assess the risk of a spiral causing even higher and more persistent inflation in the U.S. over the next few years.

What is a wage-price spiral?

The basic idea behind a wage-price spiral is simple: higher inflation causes workers to command higher wages.  In turn, higher wages increase companies’ production costs who then push those higher costs on to consumers.  This becomes a self-reinforcing cycle.

There are some necessary conditions for a wage-price spiral to take hold.  First, labor must be in relatively short supply thus giving workers enough bargaining power to drive up wages.  Second, the increase in wages must exceed growth in productivity that business can achieve through more efficient operations (e.g. from capital investment or better use of labor inputs) and thus put pressure on businesses to raise prices. A corollary to this is that the economy must be strong enough for consumers to absorb the higher process.  Finally, a strongly self-reinforcing wage-price spiral requires that workers and employers expect future inflation rates to stay high.  

In theory, a variety of mechanisms could spark a wage-price spiral.  For example, a negative supply-shock could cause a supply-demand imbalance that ignites inflation.  Alternatively, and excessively loose monetary policy or very stimulative fiscal policy could elevate income (and/or wealth) which stimulates higher demand.

Do we see evidence of a wage-price spiral in the data?

The best measure of wage inflation in the U.S. comes from the U.S. Bureau of Labor Statistics report on Employment Cost Index, or ECI.  The ECI measures the various components of workers’ incomes and allows us to home in on changes in the wages and salaries of private industry workers.  The blue line in Figure 1 shows the year-over-year percent change in the ECI for the last decade (through the end of 2021).  While annual wage growth had been increasing from about 2% to 3% per year, wages started to jump rapidly in 2021 and ended the year 5% higher than 2020.  The red line in Figure 1 shows that the consumer price index excluding food and energy, or so-called “core-CPI,” also jumped in 2021 and ended the year with annual inflation of 5.5%.  While correlation does not mean causality, the recent data does seem consistent with the early stages of a wage-price spiral.

What about other factors?

Given that we see ECI and core-CPI data consistent with formation of a wage-price spiral, it is natural to look more closely at the other necessary conditions.  First, there is strong evidence of a very tight labor market.  The unemployment rate of 4.0% in January is at a level widely considered to be near full employment. Additionally, new claims for unemployment insurance are at an all-time low (as a percent of people in the labor force).  Similarly, government data show that the ratio of the number of open positions to the number of workers seeking work is at an all-time high (see www.bls.gov/jlt/). In addition, in January 57% of businesses reported a shortage of skilled labor.¹  This evidence also suggests the broad economy is quite strong making it more likely prices increases will stick.

There is a caveat to the implications from the wage and salary data: different occupations experience quite divergent rates of increase.  For example, professional workers’ wages grew 3.7% in 2021 whereas those in service occupations (typically lower paid workers) grew 8.1%.  These differences suggest the possibility of a resetting of wages based on a new demand mix in the economy versus an across-the-board wage spike. So, rather than a permanent increase in wage inflation, we could just be seeing a one-time increase in relative wages for lower wage workers.

Another important condition is that labor productivity growth is insufficient for offsetting the growth in wages. Afterall, growing wages are a good thing as long as the gains are sustainable.  Productivity growth effectively defines that sustainable growth rate.  Here the news is mixed.  Labor productivity growth in the 4^th quarter was a very strong 6.6%.  However, much of this gain was a reversal from a week 3rd quarter and when we look at productivity growth for 2021 as a whole it averaged just 2.0%.  Consequently, it seems very unlikely that productivity growth has been sufficient to justify the 5% growth in wages and salaries.  An alternative view is that that lower skilled workers wages haven’t keep up with long-term productivity gains so an increase in wages is justified.  However, even a justified increase in wages will increase business costs and these increases could flow through into output prices.

Finally, we look at the evidence on expectations for future inflation.  Here the news is mostly good.  Despite, the significant jump in wages and inflations, the expectations of consumers about longer-term inflation has remained fairly modest.  Figure 2 plots data from a NY Fed survey showing that inflation expectations for the 1-year horizon recently jumped to 6% but only moved up to 4% for 3 years ahead.

Similarly, longer-term future inflation expectations from the bond market are also reassuring.  Differences in yield between regular US Treasury securities and Treasury Inflation Protected Securities provide a market-based assessment of inflation expectations at different horizons.  The most recent data show that expectations for inflation the next 2 years have jumped up some, but inflation expectations for 5-10 years into the future have remained unchanged at roughly 2%.  This is strong evidence that the Fed has maintained its credibility as a long-run inflation fighter even if it may feel to many like the Fed is currently behind the curve.  (But of course, the bond market has been wrong before—so this is no guarantee!)

What, me worry?

The bottom line is that the near-term economic data appear quite worrying.  There are signs that consumer price inflation and wage inflation are moving up together quite rapidly.  Add in the covid-related supply-chain disruptions, very accommodative monetary policy, and historically large fiscal stimulus, and it is a prescription for concern.  Nonetheless, the Fed increasingly appears to be on the case and markets (where investors put real money on the line) seem very confident that long-term inflation will not follow the path of the 1970s when wage-price spirals drove inflation to double digits.

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