Wages and inflation

Will faster wage growth lead to higher inflation? Discussions of wage and price spirals are in the news, but by comparing the growth rates of wages and prices, one can lose sight of what is going on with the levels. Real wages – the level of wages relative to the price level – are what matter for those receiving labor income. And what has happened to real wages during the past two years of above target inflation depends very much on which price index one uses to deflate nominal wages.

The Fed’s preferred index for measuring inflation is the personal consumption price index less food and energy prices, called core PCE). The PCE index does a better job of capturing how household substitute away from goods whose prices have risen more than average and away from goods whose prices have risen less than average. The ability to substitute across goods helps to mitigate the effect of inflation on households’ budgets. Eliminating the prices of food and energy, which tend to be volatile, can also give a better picture of future inflation. Using core PCE to deflate the BLS’s series on average hourly earnings yields an estimate of the real wage that is shown in blue in the figure. All data are monthly, seasonally adjusted and obtained from the St. Louis Fed’s FRED database; series are normalized to equal 100 in January 2020. The real wage series based on the core PCE price index suggests wages have kept up with inflation. Real wages spiked during the COVID recession and then dropped in its aftermath, but the measure has remained essentially flat since June 2020.

However, core PCE is not the only way to measure inflation. A more common measure of inflation, so common it is sometimes referred to as headline inflation, is based on the Consumer Price Index (CPI). This index does not do as good a job as the PCE does in incorporating how households shift their spending patterns in response to changing prices. Substituting to cheaper alternatives may cushion the impact of inflation, and this margin of adjustment is better captured by the chain-index PCE inflation measure, but the fact that a household needs to make such a substitution may make the price rise more salient in the household’s assessment of their cost of living. If so, CPI inflation might better capture how households assess the impact of inflation on their living standards. The red line in the figure shows what has happened to the real wage when the CPI is used instead of core PCE. The CPI-based real wage shows a steady decline between June 2020 and June 2022. Since August 2022, the CPI measure of real wages has remained essentially flat at a level approximately 4% below its June 2020 level.

Which measure of real wages might be most relevant for foretelling future wage growth? According to a Gallup Poll (April 6, 2023), inflation remains the top economic concern of Americans in 2023 as it was in 2022, with the fraction of respondents citing inflation as something they worry about “a great deal” coming in at 59% in 2022 and 61% in 2023. The number citing unemployment as something they worry about a great deal was just 32% in both 2022 and 2023.

It seems hard to reconcile how many American are worried about inflation with the stability of the real wage based on the Fed’s preferred price index. The decline in the CPI-based real wage seems much more consistent with the Gallup data. If this is the case, greater pressure for wage growth that is sufficient to boost real wages seems likely.