The myth of the wage-price spiral

Daniel Altman is the chief economist at Instawork. follow him up Twitter for real-time insight into hourly workforce trends.

There is enough blame for the huge jump in consumer prices. The highest annual inflation rate since 1981:8.6% reported in May 2022— were at least partly the result of supply chain bottlenecks, tightness in war-affected goods markets in Ukraine and workers demanding higher wages in a tight labor market. One of the reasons employees demand higher wages is to pay higher prices; according to some, this higher wage can push prices up even more. But is this upward spiral in wages and prices really so unstoppable?

The idea of ​​a wage-price spiral came into vogue in the late 1960s when the United States announced an annual consumer price inflation of more than 4% for the first time in ten years. Soon, after the oil supply shocks of the 1970s, wages and prices simultaneously increased by as much as 10% year-on-year.

Once inflation was under control, concerns about the spiral began to subside, although research in the 1980s showed that the timing of wage and price increases prolong periods of inflation† In more recent times, analysis has shown: little connection between wage changes and prices. But now, amid the highest inflation in four decades, concerns about runaway, rising costs have returned.

Given the evolution of prices and payments over the past year, I think these concerns are probably exaggerated. And one reason is simple math. Labor is not the only input for most goods and services. When labor costs rise, the costs of the other inputs do not necessarily change. So the total cost of producing a good or service does not increase as much as the cost of labor alone.

As an analogy, imagine that you are baking a cake for four people. Then you hear that four more people are coming to your party. If you just double the sugar in the cake, do you have a cake for eight? No. The pie can get bigger, but not double. In addition, the cake may not taste as great because of the change in the proportions of ingredients. You would have to double all ingredients to produce double servings.

So if hourly wages increase by 10%, we should not expect consumer prices to increase by 10% as well. Maybe they would go up by half, just 5%. With employees facing prices that were 5% higher, they could demand another 5% increase. However, this new increase could again cut production costs by half, or 2.5%.

This is not an uncontrollable wage-price spiral; it’s more of a pay-price off-ramp. Because wage changes are reflected in the total cost of production of less than one-to-one, the increases eventually disappear.

To become something terrifying, the wage-price spiral needs a little help. Specifically, it requires companies to raise prices by more than the amount necessary to cover their costs. But why would a company do this in a competitive market? Wouldn’t its competitors simply undercut its prices and bankrupt the company?

Not necessary. Sudden wage spikes and other high profile events can give companies in the same industry the opportunity to raise prices together, benefiting all of them. If they do this by colluding, it’s illegal. But a highly visible focus, such as a pay rise, allows them to coordinate informally, raising all prices with the same justification.

Sure, there’s still an incentive for one company to gain market share with lower prices, but it’s easier and more lucrative in the short term to raise prices when everyone else is. And if, say, 10% is the most important number for the wage increase, then 10% is an excellent focal point for price increases, even though the total costs have not increased that much. Prices can therefore rise just as strongly as wages, causing the wage-price spiral to become overdrive. In economic parlance, this practice is referred to as over-shifting, as companies pass on more than 100% of the increase in costs to consumers. While the term is most common in tax analysis, it can apply to anything that would normally lead to higher prices.

During the current cycle, the reality of the wage-price spiral did not look so terrifying. In the same period when consumer prices rose by 8.5%, hourly wages for private sector workers rose 5.2%and weekly earnings grew only 4.3%† If we go back another year to the start of the pandemic, prices are up 12.9% versus an 11% increase in hourly wages (the figure for total cost of workers compensationincluding benefits, is about the same).

At my company, we saw strong pay increases for flexible workers in several positions in the summer and early fall of 2021, but research shows that consumer prices rose quickly† A few reels saw pay spikes during the winter pandemic’s micro wave, but these were mostly temporary.

Now prices appear to be on a steady upward trend, but research from my company, which uses data from thousands of transactions and compares March’s figures with May, has shown that the reward mainly increasing in the service sector relating to travel and recreation. In industries related to making, selling and supplying goods, wages have remained flat in many metropolitan areas.

Clearly, labor costs are not the only driver of inflation. Either there is a shift or the prices of other inputs are rising faster than paying. In fact, experts focused on energy prices as the main instigator of broad inflation. Global factors such as the war in Ukraine continue to push up these prices even as wages stagnate, especially for low-income workers†

That said, there is room for wage increases in the coming year. with almost two unemployed for every vacancy in economics, companies that like to hire people may choose to offer higher wages along with other incentives. If they do, labor costs can contribute to rising prices, but they should lead to diminishing returns.

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