How inflation, wages and prices are interconnected

Federal Reserve Governor Lisa D. Cook spoke publically last week about the state of economic research and the current questions that exists for many tracking changes in the US economy. Governor Cook called attention to what she sees as signs that the labor market is “softening,” including a slowdown in the quit rate and hiring a reduction in the number of job openings. From December to March, the number of job openings fell by 1.6 million to 9.6 million.

Specifically, Gov. Cook’s comments mentioned the ‘strong’ increase in wages seen for “workers in the lowest-income quartile [...] relative to other quartiles over the past two years.” With far more jobs than workers seeking then, Gov. Cook said that this group “benefitted from the availability of jobs and, in many cases, the ability to move to better, higher-paying jobs in the current strong labor market.”

Federal Reserve says wage growth must slow for prices to fall

While data from the Bureau of Labor Statistics shows that between 2019 and 2021, incomes for the lowest quartile grew by thirty percent, the dollar value of the increase was the lowest of all income groups.

An effective way to evaluate income inequality among workers is by dividing them into quartiles based on their earnings. Governor Cook’s observation that the lowest twenty percent of earners saw the greatest increase compared to other groups, the percent obfuscates the fact that the nominal increase is the smallest of the group. The Federal Open Market Committee’s meeting notes from March, where participants discussed economic conditions and agreed to another rate increase, stated that most present “generally judged that some more easing in labor market tightness and slowing in nominal wage growth would be necessary for sustained disinflation.”

What officials should be considerate of is that while nominal wages have gone up, so has the poverty rate in the United States. From 2019 to 2021, the country’s poverty rate moved from 12.3 to 12.8 percent. Over the same period, the number of people experiencing homelessness rose 2.5 percent, or by around 14,700 individuals. The figure did decrease to 11.9 percent in 2020 when incomes grew thanks to federal stimulus checks, enhanced unemployment benefits, and wage increases to attract workers back into the labor force.

Over the last year, officials at the Federal Reserve have increased interest rates in an effort to decrease aggregate demand and bring down prices. While the pace of price increases is slowing, they are still rising, further cutting into purchasing power. The Bureau of Labor Statistics reported a fall of 0.7 percent in real wages over the last year; changes in real wages are calculated by tracking differences in nominal wages and subtracting the inflation rate for the same period from any increase.

How do changes in wages impact inflation?

Earlier this year, Federal Reserve Governor Christopher J. Waller described explained the central bank’s emerging view that “wages are growing faster than they have in decades [...], a pace that may contribute to keeping inflation elevated.”

Adding that across the service sector, where the worker shortages “are reportedly most acute,” firms see labor costs begin to represent a “higher share of overall input cost.”

The wage-price spiral explained

A wage-price spiral represents a situation where labor can effectively demand higher wages because of their organized power or general economic conditions. The pandemic ripped millions from the workforce, and as some companies try to attract workers, higher pay is one tool available to them. In response to higher wages, companies may increase prices, reducing the purchasing power of one’s paycheck and allowing companies to pocket that reduction. If workers are able to exert their power again and demand higher incomes, and companies increase prices, the economy enters a wage-price spiral. As recent as January, officials from the Federal Reserve made it clear that rising wages and inflation, which can are symptoms of the spiral, were not a result of the phenomena.

In mid-January, weeks before the half-a-million jobs figure was announced, Federal Reserve Vice Chair Lael Brainard said, “despite constrained supply, wages do not appear to be driving inflation in a 1970s-style wage–price spiral.”

Vice Chair Brainard added that while “wages have grown faster than the pace consistent with 2 percent inflation and productivity growth,” they “have grown slower than inflation over the past two years, and that aggregate real wages have fallen.”

The price-price spiral...

What the Federal Reserve calls a “price-price spiral,” some, like the media outlet More Perfect Union, view as price gouging.

“Retail markups in a number of sectors have seen material increases in what could be described as a price–price spiral, whereby final prices have risen by more than the increases in input prices,” said Brainard. In other words, the rate at which consumer prices are increasing does not align with the rising costs to produce, transport, and sell those products (i.e., even greater profits are being made on the backs of consumers).

Governor Waller’s comments are interesting because they do not explicitly say that labor costs have grown to a point where the viability of businesses is at risk. If labor costs became so large that the total, or that combined with other production costs, exceeded the revanue generated, then an argument could be made that the economy is not structurally sound.

However, that is not the situation the US economy finds itself. In January, consumer spending grew, and aggregate demand remained high. Still, the impacts on income inequality could be devastating. While aggregate demand is increasing, the Bureau of Economic Analysis does not report on which economic groups see increases and decreases in spending.

The risk of prices elevating at a high rate

Lastly, officials from the Federal Reserve have made it clear that they expect their intervention to raise rates to slow wage increases which “should help continue to moderate food inflation over the next few years.”

What remains unclear is whether the Fed hopes to see prices stabilize at these high levels, where household saving has fallen under four percent, or whether these actions will actually bring prices back down.