Comment: Inflation has turned growth in wages into a setback

Workers likely have noticed their higher pay; they may not realize it’s been eaten up by inflation.

By Noah Smith / Bloomberg Opinion

Many Americans have been delighted to see wages rising since the end of the pandemic. But whether they realize it yet, inflation has already eaten up all of those gains, which highlights the fact that the U.S. economy has no system for making sure that wages keep up with inflation.

In recent months, there have been lots of stories in the media about how wages are rising strongly. And in fact, in dollar terms, that’s true.

Plenty of plausible economic explanations have been offered for this happy trend: Pandemic unemployment insurance offered generous benefits to those who didn’t go back to work, forcing companies to raise wages to lure them back; the danger of covid-19 in workplaces necessitated a hazard pay premium; the rapid rise of technologies like automated restaurant ordering made workers more productive; and the Fed’s continued loose monetary policy, together with generous government relief spending, kept the economy running hot and the labor market tight.

All of these reasons make sense. And yet, when you adjust for inflation, it turns out that real wages — representing how much stuff you can actually buy with your paycheck — have gone down since May 2020 and continue to drift lower.

This is true whether or not you use consumer price inflation or the personal consumption expenditure price index, a popular alternate measure of inflation. And it’s even true when you hold occupations constant to account for the changing composition of the workforce.

In terms of real purchasing power, American workers are still losing ground.

The reason wages can look like they’re rising when they’re actually falling is inflation, of course, which has been running unusually high this year.

The typical inflation rate is about 2 percent; this year, it’s been more like 5 percent. Workers who don’t know this, or who are slow to perceive the rise in prices they pay for goods like cars and groceries, won’t realize this, and will be happy with their unusually large raises. But companies, whose accountants and managers certainly know the true inflation rate, will also be happy, because they know they’re not actually paying more for labor.

That information asymmetry between workers and employers may be exactly what keeps wages from rising faster than inflation. If workers take a year to realize how much prices have gone up, they may be satisfied with the raises they got during the time of high inflation; even if that inflation ultimately turns out to be transitory. By then, it might be too late to negotiate for a real, inflation-adjusted raise. Many people suffer from what economists call “money illusion”; they tend to think of their income and wealth in pure dollars, instead of in terms of its real purchasing power, at least in the short term. Money illusion could in turn be a source of what economists call upward sticky nominal wages: the tendency of wages not to rise too fast in dollar terms, even when there’s a burst of inflation.

In other words, even if all the aforementioned economic factors driving up wages are very real, price rises could be happening independently of wage growth and could be eating up all the gains because wages simply don’t respond to inflation very quickly. By allowing prices to rise at a rapid clip just when workers are finally getting a bit of bargaining power, the U.S. might be wasting a golden opportunity to increase living standards.

Eventually, people will realize that prices went up, and that their raises were illusory. At that point they will start getting mad. This is what happened in the 1970s, when a decade of high inflation coincided with — and possibly caused — real wage losses for the average American worker. Surveys later showed that the reason people didn’t like inflation was precisely that they thought their wages couldn’t keep up.

One possible long-term solution to this problem would be to require all companies to regularly tell workers how much their wages changed after being adjusted for inflation; perhaps every quarter or half year. Companies will resist such a change, however, since it would lead to more frequent wage negotiations, as well as removing their ability to stealthily cut wages by letting inflation do its work. Some economists will worry that this policy could cause wage-price spirals, where wages and prices push each other higher and higher.

In the meantime, falling wages give politicians another reason to worry about inflation. Many commentators hvae been urging the Federal Reserve and U.S. Congress not to be concerned. They argue that the phenomenon is transitory, and that price indices that are better measures of overheating — things like median or trimmed mean inflation — aren’t rising as fast. But the total inflation numbers represent the prices workers actually pay, and even a transitory burst of inflation will do harm if it takes away an opportunity for wage growth.

So if inflation continues for another year, and people realize their wages aren’t rising as much as they think, they could take their anger out on President Biden’s administration; much as they took their anger out on Jimmy Carter in 1980. That’s not necessarily something that the Fed should take into account in its monetary policy decision-making, but it’s probably something that should be keeping Democrats awake at night.

Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.

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