Do Wages Still Matter for Inflation?

Executive Summary

Wage growth has garnered increasing attention in the heavily watched monthly employment reports. The scrutiny reflects the emphasis many Fed officials have placed on the critical link between slack in the labor market and inflation. With wages accounting for a significant share of costs in most industries, it makes intuitive sense that rising labor costs would soon develop into higher inflation. The reality, however, is that wage growth tells us little about future inflation. If anything, the relationship runs the other way, with inflation leading wage growth.

The limited influence of wage growth on inflation reflects the changing structure of the U.S. economy. Technology is making it easier than ever for consumers to compare prices, intensifying price competition. At the same time, globalization has diminished the role of the domestic labor market with a larger share of goods consumed imported from overseas. Finally, the inability of many firms to adjust prices frequently generates the need to set prices in anticipation of future costs, making inflation expectations a more significant driver of inflation than wages.

Watching Wages for Signs of Inflation

The PCE deflator has only briefly brushed the Fed’s 2 percent target since the start of the expansion. Nevertheless, most FOMC members remain confident that inflation will move higher from here. In the Committee’s most recent economic projections published in June, the median estimate for where inflation would end the year was 1.6 percent and 1.7 percent for headline and core inflation, respectively, while both measures were projected to end 2018 at 2.0 percent. Although those estimates will likely come down a tick or two following recent months’ softness, the path remains upward and is a key factor in the Committee’s baseline outlook to further raise interest rates over the next year.

The FOMC’s confidence that inflation will head higher over the next year and a half hinges critically on the assumption that as resource slack is absorbed, upward pressure on prices follows. While resources include both labor and capital, the link between slack in the labor market and inflation garners more widespread attention. As unemployment declines, firms need to pay higher wages to attract and retain workers, and those costs in turn generate the need to raise prices. Over the past couple of years, the unemployment rate has fallen to where it is now below many estimates of full employment, while inflation—headline or core—has remained stubbornly below 2 percent. The result has been to closely watch wage growth as a sign of future inflation.

Wage growth has remained frustratingly low for workers and policymakers alike. After increasing only about 2 percent a year in the early years of the expansion, average hourly earnings began to strengthen in 2015. The uptrend has fizzled by multiple wage measures this year, however, and wage growth remains weak by historic standards. There are some signs that higher pay may be in the offing. Job openings are at an all-time high, underemployment is shrinking, and the share of small businesses raising compensation is hovering near cycle highs. But even if we see stronger wage growth, will it lead to more inflation?

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