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MainStreet Macro: Wages Go Prime Time: Part 2

July 18, 2022 | read time icon 5 min

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My kids are into memes and have been since, well, the beginning of meme history. Given that my husband and I both are economists, it was only natural that a recent family dinner conversation centered around which meme would best represent inflation.

I suggested a scale with wage growth as the fulcrum balancing prices on one side and labor demand on the other. If the labor market tightens, companies are likely to adjust the prices they charge to consumers to cover higher labor costs and balance the scale. 

Under the duress of higher cost of living, workers will negotiate even higher salaries to keep up with price increases. These two dynamics tip the scale toward higher inflation as prices chase wage increases and vice versa.

(My sons offered another meme, demonstrated with several TikTok videos, of a dog chasing its tail, which led to uproarious laughter and a discussion of NFTs.)

Last week we showed how wages bridge the tight labor market and sky-high inflation. We also released an ADP Research Institute report, “The Recent Geography of U.S. Wage Growth” that revealed how inflation and wage growth differ around the country.

So, with the scale in mind (or the dog if you prefer) here are three more ways wages are having a prime-time moment.

The biggest wage gains have been in low-cost cities

The pandemic effect on the job market was incredibly uneven, hitting low-paying jobs in consumer-facing industries the hardest. In the same way, the recovery also has had disparate geographic effects.

Our new report uncovered a never-before-seen trend.  Cities with the lowest cost of living saw the biggest jump in wages for low-paying jobs. Nationally, the top 5 percent of wage earners saw pay grow by nearly 7 percent. But growth was even stronger for low earners. The bottom 5 percent saw wages grow by more than 10 percent.

For this group, new hires drove most of the wage gains as employers had to pay more to attract workers.

During the pandemic, many families readjusted their income and spending patterns. For some, that meant relying on a single household income instead of two. For others, it meant taking advantage of remote work and more flexible work arrangements. Some were able to start their own businesses or become contractors or gig workers.

Because of these new workforce realities, employers in cities where the cost of living was low had a harder time getting workers to come back, prompting them to raise wages as an enticement. That accelerated pay gains in those low-cost regions.

The engine of inflation was still revving up in June

With a tight job market on one side and consumer prices on the other, the scale swung out of balance in June, with inflation reaching 9.1 percent, up from 8.6 percent in May.

Those price increases were broad-based and no longer confined to areas of the economy that had been hard hit by lockdown restrictions, such as airfare and hotels. Inflation now is hitting rents and medical care, categories that are much more central to the family budget.

In June, food prices at home were the highest since 1979.  Energy prices also soared. These volatile commodity-driven categories might get some relief in the next inflation report – we’ve already seen gas prices come down from where they were in June. Yet commodity prices likely will continue to swing wildly under the weight of current geopolitical uncertainty.

Rents and medical costs are more troublesome. They’re more persistent and an important component of core inflation, which tracks price movements outside of food and energy and is the metric the Federal Reserve targets when it raises interest rates.

In short, it will be a while before inflation can be tamed, regardless of the Fed’s actions, and workers will suffer if wages don’t rise to meet the challenge.

Wages, in fact, are failing to keep up

In a perfect world, wage growth would keep labor demand and prices evenly balanced. But in reality, that scale is tipping heavily under the weight of higher prices. Average real wages are down 3.6 percent from a year ago. The tight labor market and churn of the great resignation have been no match for inflation.  

That means the tradeoff between jobs and inflation isn’t working the way it did during other inflationary periods.  Even a strong job market hasn’t kept workers from losing ground to inflation.

My Take

Next week, the Federal Reserve policymakers battling inflation will meet again to determine how much to raise short-term interest rates. Given last week’s surprisingly high inflation data, they’re likely to raise interest rates by three-quarters of a percentage point, the same as they did last month. Or they could go even higher, pushing rates up by a full percentage point.

At first blush, aggressive rate hikes seem like an easy solution to inflation. But reality is much more complicated. Fed policy seeps into the economy slowly by pushing up borrowing costs and weakening consumer demand and corporate investment. Even a strong push by the central bank might take months to manifest as slower inflation. And pushing too hard now could weaken the economy down the road.

Like wages, the Fed’s monetary policy is a balancing act. Over the last 20 years, the Fed has been successful when it acted with moderate and incremental rate increases. Swinging too hard in any direction could send the economy off-kilter and harder to re-center. That dog is going to chase its tail once in a while, but can’t keep it up forever.