Strong wage growth is generally a good thing for workers and a boon for the economy.
Now? Not so much.
The Federal Reserve says average wage growth is near its highest level in decades, fueling inflation. And it could force Fed officials to raise interest rates even more next year, which risks pushing the US into a mild recession.
Economists say that moderation in wage growth is playing an important role in avoiding recession.
But it can’t be that simple.
What is the average salary increase in 2022?
According to the Labor Department’s Employment Cost Index, the average annual wage gain fell to 5.2% in the third quarter from 5.7% at the beginning of the year. But it is still up from an average of 3.3% before the pandemic and about 2% in the decade before the health crisis.
Strong pay growth is usually a good thing. However, since the COVID crisis, they have not nearly kept pace with inflation, meaning consumers are losing purchasing power.
But the increase in wage growth is contributing to inflation because employers with higher labor costs usually raise prices to maintain profits.
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Meanwhile, the Federal Reserve has sharply raised interest rates to try to tame annual inflation, which hit 9.1% in June, before sliding down to 7.1% in December.
The Fed has hiked its key rate to more than 4 percent in 2022, the most since the early 1980s, and is forecast to increase hikes next year by three-quarter points to about 5.1%. This is a level that many economists say will push the country into recession.
Fed Chairman Jerome Powell has said that the Fed will continue to raise rates until wage growth is brought under control.
Why are salaries rising so fast?
Inflation, especially in service industries such as restaurants and health care, remains high as consumers shift their shopping to activities such as eating out and traveling, while the pandemic has subsided. This has increased the demand for workers in those sectors and increased wages. Powell said price increases in those industries accounted for more than half of a key underlying inflation measure and were driven mostly by wage increases.
Labor shortages remain in those sectors as millions of Americans leave jobs during the health crisis due to COVID or early retirement. Many are not expected to return. So employers must raise salaries to attract from a smaller pool of job candidates or attract back those who have left.
“Wages are trending up … well above being in line with (the Fed’s target) 2% inflation,” Powell told a news conference this month. “We have a way to get there.”
“The labor market is still out of balance, with demand far exceeding the supply of available workers,” he added.
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What Really Happens When The Fed Raises Interest Rates?
Traditionally, the Fed raises interest rates to raise the cost of borrowing, weakening the economy and making it more expensive for companies to hire and invest. An increase in the unemployment rate typically leads to lower wage growth, and vice versa.
But the relationship between unemployment and wage growth – known as the Phillips Curve – has flattened out in recent decades, says Jonathan Miller, senior US economist at Barclays.
In the decade following the Great Depression, unemployment declined sharply while wages increased modestly. This is mainly because Americans for various reasons expected weak inflation and did not demand large increases.
As a result, Miller says, roughly each percentage point increase in the unemployment rate triggers just a quarter-point decline in wage growth. Therefore, he says, an 8 percent increase in unemployment could reduce 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 that could keep wage growth elevated, Miller says, is that job openings fell to 10.3 million in October from a record 11.5 million a year ago, but that’s still below the pre-COVID level of 7 million. above level.
Even though job growth is expected to slow as the economy loses steam next year, employers may still have to offer healthy increases to attract workers because there are fewer of them, Miller says.
Is US Inflation Declining?
Mark Zandi, chief economist at Moody’s Analytics, is more optimistic. They believe that the wage increase was driven not by a shortage of staff during the pandemic but by expectations of higher inflation.
Record gasoline prices, supply chain troubles and Russia’s war in Ukraine pushed consumer prices higher, prompting workers to make larger demands.
However, now pump prices have come down sharply and supply has tightened, reducing consumer inflation expectations for the next 12 months. According to recent surveys.
“That should lead to a reduction in wage growth,” Zandi said.
He expects annual wage growth to drop to 4% by the end of 2023 and 3.5% by mid-2024. Persuading the Fed to hold back on its rate hike as the trend becomes clear early next year.
And that, he says, should help the economy avoid a recession.