Wages are among our most scrutinized economic indicators. It’s no secret why. We’d all like a pay raise. But there’s a second, less-recognized reason. Wages are considered a precursor to higher inflation. If they rise sharply, prices will follow. That’s the theory.
It’s wrong — or at least dangerously incomplete.
This matters now. The Federal Reserve is considering when — and how much — to raise short-term interest rates, which have been held near zero since late 2008. Any acceleration of wage gains could be taken as evidence of greater inflationary pressures and justification for quicker and steeper increases in interest rates. The risk is that this conventional interpretation is mistaken.
For much of the recovery, wage gains have averaged about 2 percent annually, roughly paralleling inflation and therefore not much help in improving workers’ purchasing power.
The fact that wages haven’t sped up is widely said to demonstrate that there’s still ample “slack” in the labor market, despite persistent declines in the unemployment rate (now 5.5 percent) and hefty monthly payroll job increases (295,000 in February).
Suppose now that wage gains spurt to 3 percent or even 4 percent. Would that alert the Fed to unwanted inflationary pressures?
Well, maybe not.
It certainly would signal a tightening of labor markets. Employers pay only what’s needed to retain and recruit workers. If they raise wages, the explanation must lie in less supply (fewer available workers), more demand or both. So what? The worrisome sort of inflation doesn’t involve wages but prices — what people pay for groceries, utilities, appliances and the rest.
Higher wages drive inflation only if passed along in higher prices, and that’s not automatic.
It happened in the 1960s and ’70s. There was a classic price-wage spiral. But a spiral isn’t inevitable, as a new economic study shows. From the mid-1960s to the mid-1980s, wages and prices did chase each other — the spiral, the study found. But after the mid-1980s, “wage growth lost its ability to forecast future movements in inflation,” though the study doesn’t say why.
In reality, there are at least two ways that firms can pay for higher wages and fringe benefits without raising prices.
The first is improved productivity, aka “efficiency.” Greater efficiencies from investment, new technologies or better management practices reduce costs. Companies can use the savings to boost compensation without raising prices. Over long periods (decades, not years), the translation of advancing productivity into higher labor compensation is the main path to higher living standards.
In the short run, the second way that wages can rise without inflating prices is for labor to gain at the expense of capital (or business, if you like). Put differently: Wages can squeeze profits.
For years, the shift has been the other way. Profits have squeezed wages. From 1990 to 2014, labor’s share of national income dropped from 63 percent to 57 percent, report economists at the Federal Reserve Bank of Cleveland. Of course, businesses won’t voluntarily sacrifice profits. Competitive markets have to limit their ability to pass along higher labor costs.
So there are good wage increases and bad. The good reflect better productivity; they permanently elevate incomes and living standards. The bad result in only temporary gains; they lead to higher price inflation that erodes the purchasing power of the earlier wage increases. In an ideal world, we would now get good wage increases that would bolster household finances and prolong the recovery.
The Fed needs to keep these distinctions in mind and to do the hard detective work of identifying any future wage gains as good or bad. If policymakers are unduly conditioned by memories of the 1960s and ’70s, they could misinterpret higher wages as automatically inflationary. That’s just one possibility.
For now, price inflation is tame. The Fed should keep it that way without prematurely stifling the recovery. It’s no easy task.
Washington Post columnist Robert J. Samuelson writes about economic issues. © 2015 Washington Post Writers Group