No, Big Wage Gains Aren’t Bad News for Prices

Pop quiz: When is fast wage growth bad news? Common sense says the answer is “never,” as making more money is always a good thing for those on the receiving end of higher paychecks. But that viewpoint wasn’t too prominent when data released last week showed US wages rising 4.2% y/y in Q3, the fastest rise in over 30 years.^[i] Far from representing a nice improvement in living standards, because they followed months of above-average inflation, rising wages are allegedly signs of a potentially brewing wage-price spiral, according to some pundits. Meaning, a vicious cycle in which businesses raise wages to attract workers when inflation is high, then raise prices to preserve margins, fueling more inflation, necessitating even higher wages and more price increases, lather, rinse, repeat. As logical as this might sound, however, it has little bearing in reality, and we think investors can cross it off their list of worries.

The wage-price spiral was all the rage in the 1960s, when an economist named A.W. Phillips created a model showing a link between the unemployment rate and inflation. This model, now known as the Phillips Curve, has underpinned Fed policy for decades. It posited that when unemployment is high, businesses don’t need to raise wages to attract workers, which keeps inflation low. But when unemployment is low, according to the model, wages and inflation rise. Some Phillips Curve models use unemployment and wages, while others use unemployment and inflation. All hinge on wage-price spiral theory.

Nobel laureate economist Milton Friedman took this on in a 1968 speech entitled, “The Role of Monetary Policy,” which he delivered as an address to the American Economic Association. In it, he posited that the Phillips Curve was flawed because it focused on nominal wages, not “real” or inflation-adjusted wages. That essentially led to a model that argued inflation drives inflation, which is fatally circular. We explained this in detail a few years back in a piece that is plenty relevant today, so rather than rehash that argument, we offer you a link.

Instead, let us take on the wage-price spiral from a market perspective. Prices and wages don’t come out of thin air. They are determined in the marketplace, and they are based on supply and demand. Absent misguided government intervention, the general cycle goes like this: Shortages drive prices higher; high prices send producers signals that it is time to increase supply; higher supply stabilizes prices. We have already seen this play out with lumber this year. More recently, we have seen oil and gas producers respond to high prices by cranking up production—drilling new wells and whatnot. In the Tech world, chipmakers have responded similarly to high semiconductor prices, albeit with longer lead times delaying the supply increase. A parallel cycle plays out on the demand side, as high prices prompt users to find substitutions or use resources more efficiently. That reduces demand. In concert, these factors help stabilize or lower prices.

So it is with wages, which are really the price of labor. Starting with the supply side, as is well-documented, the civilian labor force participation rate has declined in recent years. There are a lot of reasons for this—some sociological, some economic. But as wages rise, job-seeking becomes more attractive to sidelined workers, pulling them back into the labor force. (Exhibit 1) That increases the supply of workers, which eventually stabilizes the price of labor. It isn’t instantaneous, and it isn’t a one-to-one relationship due to myriad other variables at work. But eventually, higher labor supply tends to keep wage growth in check, as there isn’t as much competition for talent. Meanwhile, on the demand side, high wages prompt many businesses to opt for efficiency gains over increasing headcount, which adds to the forces regulating the price of labor.

Exhibit 1: Rising Wages Pull People Into the Labor Force

Source: FactSet, as of 11/2/2021. Year-Over-Year Change in Average Hourly Earnings of Production and Nonsupervisory Employees and Labor Force Participation Rate, January 1965 – September 2021.

Similarly, when the price of a given product or service rises, you will tend to get much more of that product or service. For instance, if the going price for a haircut jumps from $100 to $150, that is going to entice a lot of people to cosmetology school. Soon the supply of barbers and hairdressers jumps, leading them to compete with lower prices. In the realm of physical goods, any smart widgetmaker will dial up production as prices rise, in order to boost sales and revenues. Eventually they overshoot, creating a supply glut that pushes prices back down—evidence for this is always plentiful on clearance racks and bargain shelves. Here, too, prices also regulate demand. You might opt to grow your hair out instead of paying $150 for a cut every two months. If yarn gets too expensive, you might abandon knitting and take up sewing instead. All these little substitutions multiply across the economy, helping stabilize prices. In short, companies can only raise prices if the market will bear it. Often, it won’t.

People often say the 1970s’ inflation was a wage-price spiral, but we would humbly disagree. That decade was a one-two punch of the oil shock and sweeping wage and price controls in much of the West. If you cap wages and prices and then abandon price controls, it stands to reason they will both rise, probably by much more than they otherwise would have since price signals weren’t allowed to regulate supply. Even before you abandon price controls, if a company knows the maximum price of good or service is tightly regulated amid an inflationary environment, that maximum often becomes the norm. The chief price controls in place now in major developed nations are the UK’s caps on retail electricity prices (and a few other nations’ less-extreme versions of similar restrictions). So that decade just isn’t analogous to now, in our view.

We still think today’s inflation is transitory—and price signals are a big reason why. Prices are up because of shortages, and those shortages will eventually ease as producers ramp up. That should put a lid on prices regardless of what wages do, in our view.