No Need for Radical Ideas: Wages Still Don’t Drive Inflation

Good news! A prominent UK economist has figured out how to solve inflation (broadly rising prices across the economy)! Just use the tax code to make big wage hikes impossible and presto, prices will behave. Ok, we are being a tad facetious in our framing, but this really is a serious proposal from a member of Chancellor of the Exchequer Jeremy Hunt’s Economic Advisory Council, and it comes on the heels of commentators we follow discussing faster-than-expected US wage hikes allegedly raising the risk of resurgent inflation.^[i] Yet in reality, as we will discuss, our research (and noteworthy economists) have found it is the other way around—inflation fuels wage growth. That so many see it backward despite evidence of this occurring right now is a shining example of the pessimism of disbelief that powers young bull markets (a long period of generally rising equity prices), in our view.

The error here, in our view, is an old one. Decades ago, some economists theorised that if reduced unemployment correlates with higher wages and there is a short-run tradeoff between unemployment and inflation, then wage growth must be a key inflation driver. We are oversimplifying a little so as not to bore you, but this is the essence of the so-called Phillips Curve model, and it is the theory underpinning US Federal Reserve (Fed) policy since America’s Congress enshrined it into the Fed’s mandate in 1978.^[ii] Today, it leads economists we follow to argue inflation can’t return to normal, benign rates if wages are still growing at a fast clip. Hence the concern that accompanied last week’s news that the US Employment Cost Index’s (ECI) wage growth measure accelerated to 1.2% q/q in Q3.^[iii] And the massive attention publications we follow devoted to the wage growth indicators in private payroll processing firm ADP's and the US Labor Department’s employment reports last week. And this UK economist’s suggestion that wage hikes exceeding 3.0% y/y be subject to a 100% employer-paid payroll tax.^[iv]

We think it is fair to say the Phillips Curve is rooted in some truth. When businesses compete for workers whilst unemployment is low, they tend to use higher wages to entice people. But we think the trouble comes when you extrapolate this to businesses raising prices in order to fund those higher wages … and then having to pay even higher wages to match employees’ pay with inflation … and then having to raise prices to fund those wage hikes … necessitating more wage hikes … and more price hikes … lather, rinse, repeat. In reality, businesses have other ways of funding wage hikes. They could find places to trim operating costs. They could negotiate better deals for supplies. They could swallow the hit to profit margins.

But, in our view, the crucial factor is this: When businesses set wages, they factor in inflation. That is, we think they compete with real (inflation-adjusted) wages, not nominal. So saying wage growth causes inflation amounts to a circular argument that inflation causes inflation. We think this is a basic logic fail. Nobel laureate Milton Friedman walked the world through this in the late 1960s, and his view has stood the test of time.^[v]

In reality, inflation stems from too much money chasing a finite pool of goods and services—why Friedman famously called it a “monetary phenomenon.”^[vi] Last year’s inflation spike followed global monetary policymakers’ decisions to send money supply skyward during COVID lockdowns, and it followed at the oft-described long and variable lag that usually exists between a monetary policy decision and its eventual real-world impact.^[vii] Money supply growth peaked in late 2021, and now inflation is decelerating at a late lag.^[viii] Given broad money supply is now contracting in the US and UK, we think it seems fair to presume inflation has more room to slow further.^[ix]

As for wages? They have lagged this whole time. Exhibit 1 shows US headline CPI inflation and wage growth (as measured by the Atlanta Fed branch’s wage growth tracker, which measures the same people’s pay over time rather than broad averages, which are subject to skew from things like high-earner retirements and new labour market entrants). Prices started accelerating in early 2021, months before wages did. Wage growth’s moderation has also followed inflation’s slowdown, to the point that households are only just now regaining some purchasing power. As shown in Exhibit 2, notwithstanding early 2001’s brief, temporary spike in wage growth resulting from COVID lockdowns a year earlier, UK wages started accelerating after inflation and appear to have crested in July, whilst inflation has decelerated irregularly since peaking in October 2022. 

Exhibit 1: US Wages Lag Inflation

Source: FactSet and Atlanta Fed, as of 6/11/2023. Headline CPI inflation rate and Atlanta Fed wage growth tracker, December 2020 – September 2023.

Exhibit 2: UK Wages Lag Inflation

Source: ONS, as of 6/11/2023. Average weekly earnings excluding bonuses (rolling 3-month average) and CPI including owner-occupiers’ housing costs, year-over-year changes, December 2020 – August 2023. Wage growth data run through July 2023.

So no, we don’t think taxing away the incentive to hike wages more than 3.0% per annum would tame or prevent high inflation. If that policy were in place now, it would likely entrench worse living standards, making households unable to regain lost purchasing power in anything resembling a timely fashion. To us, it sounds like a recipe for an economic malaise.

Not that it stands much chance of passing, in our view. An economist with the Chancellor’s ear might champion it, but other prominent voices are already shouting it down with the simple observation that wages lagged prices.^[x] Then too, the ruling Conservative Party is quite gridlocked, and passing legislation this contentious will likely be a no-go for many with a general election on the horizon (due by January 2025). So we don’t think this is some massive risk in waiting for UK stocks.

Instead, we think all this wage frustration is a positive sign for stocks. In our view, it means a key economic driver is broadly underappreciated—which we find is a hallmark of sentiment early in a bull market. Stocks may be in a sentiment-fuelled dip for now, based on our analysis, and we know that can be difficult to endure.^[xi] But as markets eventually resume weighing fundamentals, we think they should have plenty of wall of worry to climb.