Wage Growth, Labor Market Tightness, and Inflation: A Service Sector Analysis

Figure 1 displays scatter plots of the relationship between labor market tightness and nominal wage growth. The figure shows that, starting from 2022, both labor market tightness and wage growth have been significantly above prepandemic averages for all the service sectors. However, there have been declines in both labor market tightness and wage growth starting from early 2023. Echoing the recent work of Benigno and Eggertsson (2024), the data are suggestive of a kink in the post-pandemic correlation between labor market tightness and wage growth, particularly for education and health services, leisure and hospitality services, and trade and transportation services. For instance, the correlation between labor market tightness and wage inflation in the education and health services sector became a lot stronger once tightness exceeded a value of about 2. The economy continues to be on the steeper side of the correlation, implying that a small decline in labor market tightness is associated with a much larger decline in nominal wage growth.

The heightened nominal wage growth might also reflect improvements in labor productivity growth. To account for this, I consider a measure of productivity-adjusted wage inflation, constructed by deducting trend labor productivity growth from nominal wage growth for each sector. Figure 2 emerges when nominal wage growth is adjusted for trend labor productivity growth at the sector level.¹ The figure is generally similar to Figure 1. The only exception is for leisure, hospitality, and other services, for which productivity-adjusted wage growth has re-equilibrated back to its prepandemic average.

Implications for Services Inflation

Given persistently elevated inflation readings in the services sector following the pandemic, a key question is the extent to which nominal wage growth feeds into price inflation. To capture this relationship, I use the local projections methodology of Jordà (2005) and employ a specification like that in Heise, Karahan, and Şahin (2022) by running the following regression:

where ${\pi }_{it}$ is inflation in period t and sector i, $\mathrm{\Delta }{W}_{it}$ is nominal wage growth, $u_{it}$ is the unemployment rate, ${\bar{\pi }}_t$ is a measure of long-run inflation expectations, and ${\epsilon }_{it}$ is an error term.² The estimation is performed on monthly data from January 2001 through February 2024, and I exclude data from the second and third quarters of 2020 in the cases of the education and health services and leisure, hospitality, and other services industries.³ Of interest for this Economic Commentary is the association between changes in current nominal wage growth and inflation in that sector h-months ahead, that is, the estimates of ${\beta }_{ih}$ for h = 0, 1, ..., 36 months.

Figure 3 plots the point estimates of ${\beta }_{ih}$ over a three-year horizon for all four sectors of interest. The figure shows that there is considerable heterogeneity in the estimates of ${\beta }_{ih}$. First, current wage growth is positively associated with sector-specific inflation only for education and health services and leisure, hospitality, and other services. By contrast, I do not find a statistically significant relationship between current wage growth and the inflation rate for financial and business services or for trade and transportation services at any horizon within three years. Second, there are important differences in terms of the timing for when wage growth is most strongly associated with future price inflation in the education and health services and leisure, hospitality, and other services. Specifically, in education and health services, higher wage growth today is associated with higher inflation after about one year, and, from that point, the elevated inflation persists for about one year. On the other hand, high current wage growth tends to be associated with high inflation almost immediately in leisure, hospitality, and other services, and that higher inflation lasts for about one year.

Figures 4a and 4b attempt to capture the implications that the recent slowing in sector-specific wage growth, as shown in Figure 1, will have for the corresponding sector-specific inflation rates going forward if the relationship in Equation (1) holds. Specifically, I compute the anticipated change in sector-specific inflation rates that would be expected to follow changes in wage growth within that sector that occurred at three particular points in time: between the end of October and end of November 2022 (left), the end of May and end of June 2023 (center), and the end of December 2023 and end of January 2024 (right). The panels in Figure 4a plot the changes in the inflation rate of education and health services, and the panels in Figure 4b plot the changes in the inflation rate of leisure, hospitality, and other services. The red dashed line indicates February 2024. Figure 4a shows that in education and health services, there is still some upward pressure on inflation expected to occur through the end of 2024 as a result of the earlier increases in wage growth in late 2022 and early 2023 in that sector. The analysis implies that it will take some time before the more recent easing in wage growth in this sector from mid-2023 onward is likely to pass through to lower inflation rates in late 2024 and into 2025. On the other hand, given the shorter time lag between wage growth and inflation in leisure and hospitality services, earlier upward pressure on inflation arising from increases in wage growth has already passed, and the more recent declines in wage growth that started happening from 2023 onward should help to reduce inflation in that sector.

This analysis highlights that the relationship between wage growth dynamics and inflation varies substantially across sectors. First, the decline in the wage growth in some service sectors will not necessarily lead to lower inflation in those sectors. Second, inflationary pressures resulting from wage growth are expected to be elevated in the education and health services sector through 2024 before the disinflationary effects of past wage growth declines start to materialize by the end of 2024 and into 2025. Third, the easing seen thus far in wage growth in the leisure, hospitality, and other services sector should soon help to moderate inflation in this sector. However, it is worth noting the earlier finding that wage growth adjusted for labor productivity in the leisure, hospitality, and other services sector has already returned to prepandemic levels, suggesting that to see even more disinflation in this sector would require a bigger reduction in labor market tightness.

Conclusion

This Economic Commentary investigates the connections among labor market tightness, wage growth, and price inflation at the service sector level. Sector-specific labor market tightness and nominal wage growth have been above prepandemic averages since 2022, and a stronger positive relationship between labor market tightness and nominal wage growth has emerged in the aftermath of the pandemic. The relationship between wage growth dynamics and inflation varies substantially by sector. Higher sector-specific wage growth is associated with an increase in inflation in the education and health services sector with a lag of about one year, whereas the relationship is almost immediate for leisure and hospitality services inflation. On the other hand, I do not find significant pass-through from wages to prices in financial and business services or trade and transportation services.