Wages, Expectations, and Prospects for Inflation
Over the past six months, food and energy prices have risen at an annualized rate of 17 percent, prompting speculation of a possible price-wage spiral that will result in rampant inflation. A wage-price spiral occurs when wage earners start to demand higher nominal wages just to keep up with rising inflation (trying to hold real incomes constant). In turn, these wage increases raise the costs of production, which squeezes margins and induces business owners to raise prices. These even-higher prices then push wage earners to try and negotiate even higher wages, which again prods businesses to raise prices, and so onâ€¦resulting in a rapid run-up in inflation.
For some, this argument may be a nonstarter, given that a wage-price spiral usually requires competitive (or “tight”) labor markets. In the absence of a tight labor market, the wage-earner will not hold enough bargaining power to be able to force the firm to acquiesce. With an unemployment rate at 9.0 percent and an employment-to-population ratio that has barely edged up from its current cyclical low, it would be hard to argue that labor markets are anything close to “tight.” Nevertheless, we have some data that might help spot this inflationary pressure, should the pace of economic activity quicken and labor market slack dissipate.
As workers and business owners start to see price pressure building, their concern is likely to play into their inflation expectations. Median year-ahead inflation expectations actually edged down to 4.1 percent in May, compared to 4.6 percent in April. The statement that accompanied the data release noted that the downtick was connected to an expectation that gas prices will decrease. Longer-term (5- to 10-year) median inflation expectations held at 2.9 percent in May, remaining near pre-recession levels. Moreover, the latest estimate from the Cleveland Fed’s model of inflation expectations suggests that the public expects inflation over the next 10 years to average a relatively low 1.9 percent.
Another measure of forewarning about a wage-price spiral can be gleaned from certain survey data. In addition to inflation expectations, the University of Michigan’s Survey of Consumers also asks participants about their future income prospects. They are asked: “By about what percent do you expect your (family) income to increase during the next 12 months?” Individuals who feel confident about their ability to demand higher wages in response to rising prices would likely expect rising family income. In stable economic conditions, individuals typically expect their family’s income to roughly keep pace with inflation. However, about midway through the last recession, the median expectation plummeted from around 2.0 percent to near zero, and it has continued to hover at an all-time low of 0.2 percent. If inflation were to increase at about 2 percent over the next year and the income expectation materialized, that would mean the median individual’s real income would fall.
Data on compensation tell a similar story about the lack of wage pressure. The Employment Cost Index (ECI)—which includes wages, salaries, and employer costs for employee benefits—slowed markedly during the recession, bottoming out at a four-quarter growth rate of 1.4 percent shortly after. While the year-over-year trend has edged up to 2.0 percent as of the first quarter of 2011, it is still 1.3 percentage points below its 20-year average.
In light of relatively slow compensation growth, slack labor markets, and a somewhat bleak expectation of future income gains, it’s hard to imagine that recent spikes in food and energy prices have touched off a price-wage spiral. More likely, these relative-price increases will cause consumers to trim spending elsewhere in their budget or save less before they go asking for a raise.