Can a wage-price spiral be avoided?
Published November 18, 2021
Who doesn’t like to be paid more? Maybe there a few workers who are indifferent to their earnings, but I haven’t met them yet. Obviously being paid more means workers can buy more of what they want for themselves, their families, and even charities they support.
The apparent good news is that worker earnings, as measured by their wage rate (earnings per hour), have been on the rise. Over the last year, average private-sector wage rates have risen almost 5% in the nation and over 6% in North Carolina. This is the fastest increase in more than a decade.
Of course, wage rates can rise for several reasons. One is as a reward for working better. If a worker’s productivity – the fancy economics term for working better – increases, then the worker is more valuable to their employer, and a higher wage rate reflects that.
Economic sectors or occupations that are experiencing growth often will lead to higher wage rates. The higher pay is a signal to attract more workers from other industries and jobs.
Then there is the important impact of inflation on wage rates. Inflation measures the change in the cost-of-living. When inflation is positive, the cost-of-living is rising. When inflation is negative (also called “deflation”), the cost-of-living is falling. Positive inflation is the norm. The last time we had deflation was 2009, which was a recession year.
Since inflation raises the cost-of-living, this means people need more money to achieve the same standard of living. For example, if inflation during the year is 5%, then people need 4% more income to maintain their buying. If income rose only 2%, then buying power would effectively drop by 3%.
There are some situations where people receive an automatic adjustment in their income due to inflation. The best example is Social Security benefits. Rather than being a fixed income, since 1975 Social Security benefits have been automatically adjusted each year to account for inflation. This is called a “cola”, or cost-of-living-adjustment. In 2022, Social Security retirement benefits will be increased by 5.9% to account for the previous year’s price increases. Some – although not many – private sector contracts – have similar automatic “colas.”
An important take-away from this discussion is that workers should always compare changes in their earnings to the inflation rate. And if their earnings are rising less than inflation, then their buying power is actually going down.
This is exactly the problem today. With the latest numbers showing the inflation rate during the last year at over 6%, inflation is wiping out most or all of the pay gains workers have seen. It’s understandable if workers lobby their bosses for more pay gains.
Yet what’s best on the individual level might not be good for the aggregate level. The danger is the development of – what economists call – a “wage-price spiral.”
A wage-price spiral develops when inflation becomes expected and ingrained in the economic system. The spiral goes like this. Inflation occurs and workers realize their standard of living is dropping. They push for pay raises to counteract inflation. Since wages and salaries account for 70% of business’s costs, increasing worker pay prompts businesses to increase customer prices. Yet the increase in prices sparks a new round of inflation, and the process continues. The economy is put on a continuous treadmill of higher and higher inflation.
We had a wage-price spiral occur in the late 1970s, ultimately pushing the annual inflation rate to reach double-digit rates. The spiral ended when the Federal Reserve significantly raised interest rates and slowed buying and spending, but also plunged the economy into a serious recession.
Some analysts see a similarity to today’s inflationary situation. They worry the idea of continuous inflationary pressures will become expected, and thus will generate a self-fulfilling prophesy of on-going significant price increases. If this happens, it will take an extraordinary effort to put inflation back in the box.
However, there is an alternative view that most of today’s inflation is related to temporary snags in the supply chain. Once these snags are eliminated – say these economists – inflation will subside. However, many analysts say this could take us well into next year.
With its control over the money supply and interest rates, the Federal Reserve is also a key to containing inflation. During the hyper-inflation of the 1970s, the Fed moved too slowly, and when they did change policy it had to be big and bold, which – unfortunately – led to a recession.
Everyone wants to protect themselves from inflation. We will naturally act in our own self-interests by asking for higher earnings to counter higher prices. But we need public institutions – like the Federal Reserve – to look at the big picture. We want to avoid a wage-price spiral and put the economy to on a path to grow with much lower inflation.
This is a tall order. Will it be met? You decide.
Walden is a William Neal Reynolds Distinguished Professor Emeritus at North Carolina State University.