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Markets and Economy

Why Higher Wages Don’t Always Lead to Inflation

In the past, rising wages drove up consumer prices. Today, employee wage increases are being driven by competition and widening corporate profit margins rather than inflationary pressures.
Jim Glassman, Head Economist, Commercial Banking
February 7, 2018

Hourly wages have risen almost 3 percent since January 2017, a welcome acceleration in earnings for many workers. While larger paychecks are good news for the American labor force, rising compensation has also sparked some concern of spiraling inflation. However, a closer look shows that these worries are premature.

The current acceleration in wages is primarily tied to productivity gains and the shifting composition of the economy, not inflationary pressure. When inflation does arrive, it’s much more likely to be driven by an unsustainable level of aggregate demand that affects the entire economy and not just worker compensation.

No More Price Markups

In past decades, when the US economy was more regulated and less competitive, rising wages often drove up consumer prices. The automotive industry of the 1960s provides a good example. The domestic automobile market was dominated by three major automakers, who in turn relied on a single union to supply labor for its factories. Automakers could negotiate wage hikes for their workers, confident in the knowledge that they would recoup higher labor costs in the showroom. Across the economy, highly regulated industries could apply similar markup strategies that tied wages directly to prices.

Today, that model is effectively dead. If increased labor costs force an automaker to raise prices, the manufacturer will simply lose market share to more efficient competitors. Deregulation and global competition have severed the direct link between pay raises and consumer prices.

Noninflationary Wage Gains

For the past two decades, compensation trends have been driven by productivity. When businesses increase pay to attract and retain a more productive workforce, the wage increase is fundamentally noninflationary. Workers are earning more, but they are also contributing more to the company’s bottom line; as such, employers are rarely forced to raise the price of goods to meet higher payrolls.

Notably, incentive-based bonuses have accounted for a growing share of wage gains in recent years. This is a sign that businesses are channeling more resources toward their highest-performing employees and linking increased compensation to stronger productivity.

Tax reform may also contribute to noninflationary wage gains in the coming years. The headline corporate tax rate has been slashed from 35 to 21 percent, giving corporations more flexibility with their spending. Competition makes it likely that businesses will spread the windfall from tax savings throughout the workforce.

Components of Inflation

In the modern economy, inflation is driven by rising aggregate demand. In a truly overheating economy, aggregate demand will outstrip the nation’s ability to supply virtually everything. While the cost of labor is an important cost of doing business, so is the cost of raw materials—including energy goods and services, debt service and depreciation of productive resources. But cost trends are more likely to reflect business conditions and pricing power than to drive inflation trends. Future price pressures will be broad-based and unlikely to start with wage gains that spill into retail prices.

The labor market still contains considerable slack, with as many as 2 million discouraged workers still available to return to the job market as conditions improve. The US economy should be able to support above-trend growth for some time, especially as new technologies help boost worker productivity.

Rising wages may partially reverse the labor market’s shrinking share of GDP, but climbing compensation is unlikely to generate direct inflationary pressure in today’s highly competitive economy.

View our economic commentary disclaimer.

 

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