Strong wage growth is normally a good thing for workers and a boon for the economy.
Now? Not so much.
Average wage growth is nearing its highest level in decades, fueling inflation, the Federal Reserve says. And that could force Fed officials to raise interest rates even more next year, risking pushing the U.S. into a mild recession.
Economists say moderating wage growth is key to avoiding a downturn.
But it may not be that simple.
What is the average salary increase in 2022?
Average annual wage growth fell to 5.2% in the third quarter from 5.7% early this year, according to the Labor Department’s Employment Cost Index. But that̵[ads1]7;s still well above the 3.3% average before the pandemic and about 2% in the decade before the health crisis.
Robust wage increases are usually a good thing. Since the covid crisis, however, they have not nearly kept up with inflation, which means consumers are losing purchasing power.
But the increase in wage growth contributes to inflation because employers with high labor costs usually raise prices to maintain profits.
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Meanwhile, the Federal Reserve has raised interest rates sharply to lower annual inflation that reached 9.1% in June before settling to a still high 7.1% in December.
The Fed has raised its key rate by more than 4 percentage points in 2022, the most since the early 1980s, and projects another three-quarters of a point in increases next year to around 5.1%. That’s a level that many economists say will lead the nation into recession.
Fed Chairman Jerome Powell has said that the Fed will continue to raise interest rates until wage growth is contained.
Why are wages rising so quickly?
Inflation, particularly in service industries such as restaurants and health care, has remained high as consumers shift their purchases to activities such as dining out and travel now that the pandemic has subsided. This has created demand for workers in these sectors and pushed up wages. Powell said that 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 persist because millions of Americans quit during the health crisis due to COVID or early retirement. Many are not expected to return. So employers must raise wages to draw from a smaller pool of job candidates or lure back those who quit.
“Wages are running … well above what would be consistent with 2% inflation (the Fed’s target),” Powell said at a press conference this month. “We have a ways to go to get there.”
He added, “The labor market continues to be out of balance, with demand significantly outstripping the supply of available workers.”
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What actually happens when the Fed raises interest rates?
Traditionally, the Fed raises interest rates to increase borrowing costs, weaken the economy and make it more expensive for companies to hire and invest. An increase in unemployment typically leads to a lower wage increase, and vice versa.
But the 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 following the Great Recession, unemployment fell sharply while wages rose modestly. That is largely because Americans came to expect weak inflation for various reasons and did not demand large increases.
As a result, Millar says, roughly every percentage point increase in unemployment triggers only a quarter-point drop in wage growth. So, he says, it could take as much as an 8 percentage point increase in the unemployment rate to shave 2 percentage points off wage gains 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, says Millar, is that vacancies have fallen from a record high of 11.5 million a year ago to 10.3 million in October, but it is still well above the pre-COVID level of 7 million.
Although job growth is expected to slow as the economy slows next year, employers may still need to offer healthy wages to attract workers because there are fewer of them, Millar says.
Is inflation in the US going down?
Mark Zandi, chief economist at Moody’s Analytics, is more startling. He does not believe wage growth was driven higher during the pandemic by a shortage of workers, but rather by high inflation expectations.
Record gasoline prices, supply chain problems and Russia’s war in Ukraine drove consumer prices higher, prompting workers to demand bigger increases.
Now, however, pump prices have fallen sharply and supply issues have improved, reducing consumer inflation expectations for the next 12 months, according to recent research.
“That should bring wage growth down,” Zandi said.
He expects annual wage increases to fall to 4% by the end of 2023 and 3.5% by mid-2024, enticing the Fed to lower rate hikes when the trend becomes apparent early next year.
And that, he says, should help the economy avoid a recession.