Strong wage growth is generally a good thing for workers and a boon for the economy.
Now? Not much.
Average wage increases are nearing their highest levels in decades, fueling inflation, the Federal Reserve says. And that could force Fed officials to raise interest rates more next year, risking pushing the U.S. into a mild recession.
Economists say that moderating wage growth is shaping up as the key to avoiding recession.
But maybe it’s not that simple.
What is the average salary increase in 2022?
Average annual wage gains fell 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 higher than the average of 3.3% before the pandemic and about 2% in the decade before the health crisis.
Steady salary increases are usually a good thing. Since the COVID crisis, however, they haven’t nearly kept up with inflation, meaning consumers have lost purchasing power.
But rising wages contribute to inflation because employers with high labor costs often raise prices to maintain profits.
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On the other hand, the Federal Reserve raised interest rates sharply to lower annual inflation that hit 9.1% in June before dropping to a still high 7.1% in December.
The Fed raised its key rate by more than 4 percentage points in 2022, the most since the early 1980s, and forecast another three-quarters of a point increase next year to about 5.1 %. That’s a level that many economists say will send the country into recession.
Fed Chair Jerome Powell said the Fed will continue to raise rates until wage growth is there.
Why are wages rising so quickly?
Inflation, especially in service industries such as restaurants and health care, remains high as consumers shift their purchases to activities such as dining out and travel now that the pandemic has eased. That stimulated demand for workers in those sectors and pushed up wages. Powell said that industrial price increases make up more than half of a key underlying measure of inflation and they are mostly driven by rising wages.
Job shortages in those sectors persist as millions of Americans quit during the health crisis due to COVID or take early retirement. Many are not expected to return. So employers have to raise wages to get from a smaller pool of job candidates or attract leavers.
“Wages are running … more than what’s consistent with 2% inflation (the Fed’s target),” Powell said at a news 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 exceeding 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 the cost of borrowing, weakening the economy and making it more expensive for companies to hire and invest. An increase in the unemployment rate usually leads to a lower salary increase, and vice versa.
But that relationship between unemployment and wage growth – known as the Philips Curve – has broken down in recent decades, said Jonathan Millar, senior US economist at Barclays.
In the decade following the Great Recession, unemployment fell sharply while wages rose modestly. That’s largely because Americans expect weak inflation for a variety of reasons and aren’t asking for big increases.
As a result, Millar says, almost every percentage point increase in the unemployment rate causes only a quarter point drop in wage growth. So, he said, it could take as much as an 8 percentage point increase in unemployment to cut wage gains by 2 percentage points to 3% to 3.5%. Such a scenario would mean a severe recession.
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Another factor keeping wages up, Millar said, is that job openings fell from a record high of 11.5 million a year ago to 10.3 million in October but that’s more at the pre-COVID level of 7 million.
Although job growth is expected to slow as the economy loses steam next year, employers can still offer healthy raises to attract workers because they are scarce, Millar said. .
Will US inflation fall?
Mark Zandi, chief economist at Moody’s Analytics, was better. He does not believe that wage growth is higher during the pandemic because of a lack of workers but because of high inflation expectations.
Record fuel prices, supply chain problems and Russia’s war in Ukraine have pushed up consumer prices, prompting workers to demand bigger raises.
Now, however, pump prices have fallen sharply and supply snags have widened, lowering consumer inflation expectations over the next 12 months, according to recent surveys.
“That should lead to wage growth,” Zandi said.
He expects annual salary increases to fall to 4% by the end of 2023 and 3.5% by mid-2024, urging the Fed to scale back its rate hikes as the trend becomes clear early next year.
And that, he said, should help the economy avoid a recession.