Hotter-than-expected inflation has rekindled fears about a wage-price spiral. Writing in the Wall Street Journal, Jason Furman argues the Fed should tighten even faster. The economy’s “underlying inflation” is due to “extremely tight labor markets,” he writes. Although Furman prefers the phrase “wage-price persistence,” his position is clear: central bankers must push against the “rapid wage gains that passed through as higher prices.”
The implied wage-price dynamic is a positive feedback loop. Faster wage growth pushes up costs for businesses; businesses raise output prices to maintain their margins; workers demand higher wages to keep up with the cost of living. It seems plausible. Yet, on further inspection, assertions of a wage-price spiral run afoul of basic economics.
Higher wages don’t cause inflation. They merely reflect inflation that’s already happening.
Economists have a pretty good understanding of the market forces that determine wages. As with nearly everything else, the place to start is supply and demand. Businesses’ demand for labor depends on productivity: the more workers are able to produce, the more employers are willing to pay. Workers’ supply of labor depends on the labor-leisure tradeoff; the higher the payoff from working, the more workers will give up their valuable leisure time. Wages will balance the labor-hours demanded with the labor-hours supplied.
Importantly, wages are a relative price: the price of rented labor. Remember that inflation is about prices in general. These are two very different phenomena. Wages are a matter of price theory, whereas the dollar’s purchasing power is a matter of monetary theory.
Focusing on the demand side of labor markets shows why the wage-price spiral is a bogus idea. Businesses can’t afford to pay workers more than the value they add to the production process. Suppose I own a Dunkin’ Donuts franchise. I currently have four employees on the morning shift. If I estimate that hiring a fifth worker will add $15 per hour to my bottom line, the absolute most I will pay that worker is $15 per hour. It doesn’t matter if the worker insists on more because of inflation; I’m not going to hire someone at a loss. Wages are pinned down by productivity. Inflation, which affects prices in general rather than the price of labor, doesn’t change this.
According to the Atlanta Fed’s wage tracker, nominal (not adjusted for inflation) wages are rising at about 6 percent per year. This is slightly higher than year-over-year inflation (5.4 percent) and slightly lower than the annualized version of the most recent monthly rate (7.2 percent). Since labor productivity has fallen since the pandemic, there might be a partial link between labor markets and inflation on the supply side. But much of the wage growth we’re seeing reflects old-fashioned, monetary-expansion-induced, demand-side dollar devaluation. Causality runs from inflation to wage growth, not the other way around.
Furman is right to insist the Fed continue tightening. The recent uptick in inflation is worrying, and the Fed needs to get a handle on the situation before higher inflation expectations become entrenched. But the Fed doesn’t need to take a sledgehammer to labor markets to ease the economy’s pricing pressures.
The Fed hiked its target for the federal funds rate eight times last year, with negligible, if any, harm to workers. As Alan Blinder recognizes, “Some observers insist that conquering inflation requires a recession. But that’s based on Phillips curve reasoning: high unemployment is supposedly needed to slow the growth of wages, which in turn will slow the growth of prices.” This faulty paradigm has proved wrong “for most of the 20th century,” and is conceptually incoherent, besides.
Stay the course, Mr. Powell, and don’t concern yourself with wages. Supply and demand will sort them out. Instead, get inflation-adjusted interest rates above zero and keep them there until the economy is convinced you mean business. The best thing you can do for workers is make the dollar’s purchasing power as predictable as possible by making inflation small and steady again.