Strong wage growth is usually good for workers and a boon for the economy.
Now? Not as much.
Average wage increases are nearing their highest level in decades, fueling inflation, Federal Reserve says. And that could force Fed officials to raise rates even more next year, which could push the US into a mild recession.
Economists say moderate wage growth is proving key to avoiding a downturn.
But it might not be that easy.
What is the average wage increase in 2022?
Average annual wage increases eased to 5.2% in the third quarter from 5.7% earlier this year, according to the Labor Department’s employment cost index. But that’s still well above the average of 3.3% before the pandemic and about 2% in the decade before the health crisis.
Robust raises are usually a good thing. However, since the COVID crisis, they have not come close to keeping up with inflation, meaning consumers are losing purchasing power.
But the rise in wage growth contributes to inflation, as employers with high labor costs typically raise prices to maintain profits.
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Meanwhile, the US Federal Reserve has raised interest rates sharply to bring down annual inflation, which hit 9.1% in June before falling to a still elevated 7.1% in December.
The Fed raised its benchmark interest rate by more than 4 percentage points in 2022, the sharpest since the early 1980s, and forecasts further increases of three quarters of a point to around 5.1% next year. That’s a level that many economists say will plunge the nation into recession.
Fed Chair Jerome Powell said the Fed will keep raising rates until wage growth is contained.
Why are wages rising so fast?
Inflation, particularly in service industries like restaurants and healthcare, has remained high as consumers shift their purchases to activities like dining out and travel after the pandemic subsides. This has fueled demand for labor in these sectors and pushed up wages. According to Powell, price increases in these industries account for more than half of a key underlying measure of inflation and are mainly driven by wage increases.
Labor shortages in these sectors continue as millions of Americans resigned due to COVID or early retirement during the health crisis. Many are unlikely to return. So employers have to raise wages to draw from a smaller pool of job applicants or to lure back those who have left.
“Wages are … well above what would be consistent with 2% inflation (the Fed’s target),” Powell said at a news conference this month. “We have a way there.”
He added: “The labor market has continued to be unbalanced as demand far outstrips the supply of available labour.”
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What happens when the Fed hikes interest rates?
Traditionally, the Fed has hiked interest rates to increase the cost of borrowing, weaken the economy and make it more expensive for businesses to hire and invest. An increase in the unemployment rate usually leads to lower wage increases and vice versa.
But that relationship between unemployment and wage growth — known as the Philips curve — has frayed in recent decades, says Jonathan Millar, senior US economist at Barclays.
In the decade after the Great Recession, unemployment fell sharply while wages rose slightly. This is mainly because, for a variety of reasons, Americans expected weak inflation and didn’t demand big pay rises.
As a result, Millar says, for every roughly one percentage point increase in the unemployment rate triggers only a quarter-point decline in wage growth. So he says it could take an 8 percentage point increase in unemployment to reduce wage growth by 2 percentage points to 3% to 3.5%. Such a scenario would mean a severe recession.
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Another factor that could keep wage growth high, according to Millar, is that job vacancies fell to 10.3 million in October from a record high of 11.5 million a year ago, but still well above the level of 7 million before lying.
Although job growth is expected to slow as the economy slows next year, employers may still need to offer healthy pay rises to attract workers as there are fewer of them, Millar says.
Is US inflation declining?
Mark Zandi, Moody’s Analytics chief economist, is more optimistic. He doesn’t think labor shortages have pushed wage growth higher during the pandemic, but high inflation expectations.
Record gas prices, supply chain problems and Russia’s war in Ukraine pushed up consumer prices and prompted workers to demand higher pay rises.
However, now pump prices have fallen sharply and supply shortages have improved, lowering consumer inflation expectations over the next 12 months, according to recent polls.
“That should slow wage growth,” Zandi said.
He expects annual pay increases to drop to 4% by the end of 2023 and 3.5% by mid-2024. persuading the Fed to taper its rate hikes once the trend becomes clear early next year.
And that, he says, should help the economy avoid a recession.
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