Wages, Wage-Price Spirals, Inflation, and the Echoes of History
Reflections on the November 2024 jobs data and a look at wage-price spirals - and how we've dealt with them - through the years.
The intersection of labor, wages, and productivity has been a recurring theme in conversations I've had over the past four years—whether with clients, friends, or colleagues. Business leaders often voice concerns about rising wages and what they see as declining productivity, highlighting the pressure these trends place on margins. Meanwhile, employees I’ve spoken with are adamant that they’re working harder and smarter than ever before.
This disconnect raises a fascinating question: how do we define and measure productivity in today’s economy? And how do these perceptions—and the data—shape the broader narrative of labor market dynamics?
The November 2024 jobs report offers a compelling snapshot of the U.S. labor market’s current dynamics. With 227,000 new jobs added—a notable rebound from October’s weather- and strike-affected slowdown—the data underscores the resilience of the economy. Meanwhile, average hourly earnings continued their steady climb, reflecting strong demand for workers but also stirring concerns about potential inflationary pressures.
So, naturally, we need to ask ourselves: are rising wages a welcome sign of a healthy job market, or do they risk setting off a wage-price spiral that could destabilize the broader economy?
What Is a Wage-Price Spiral?
A wage-price spiral occurs when rising wages lead to higher production costs, prompting businesses to increase prices. In turn, workers demand higher wages to keep up with inflation, creating a self-reinforcing cycle. While wage growth is generally positive for workers and can boost consumer spending, it becomes problematic when it significantly outpaces productivity or when businesses are unable to absorb higher costs without passing them on to consumers.
The phenomenon is not new. Economists have long studied the conditions under which wage growth fuels inflation, with notable examples emerging from the mid-20th century.
Here’s a quick figure to illustrate how wage-price spirals work.
The figure shows how inflation can get out of hand. It starts when there's an increase in demand for goods and services, shifting the aggregate demand curve to the right (from AD0 to AD1). This pushes up prices (point B).
Workers then demand higher wages to keep up with the rising cost of living. This increases production costs for companies, shifting the aggregate supply curve upward (from AS0 to AS1).
Companies respond by raising their prices again to cover the increased labor costs. This leads to even higher wage demands, and the cycle continues as the supply curve shifts further upward (to AS2).
This cycle of rising prices and wages is called a wage-price spiral. It can lead to high inflation, which means the prices of everything are going up quickly.
The 1970s Wage-Price Spiral
The late 1970s offer a textbook example of a wage-price spiral gone awry. During this period, inflation soared to double-digit levels, driven by several factors: rising energy prices following the oil embargo, strong wage growth in heavily unionized sectors, and a lack of productivity gains to offset labor costs.
Labor contracts often included automatic cost-of-living adjustments (COLAs), which tied wage increases to inflation. As prices rose, wages followed suit, further fueling inflation in a vicious cycle. Businesses, unable to absorb these rising costs, passed them on to consumers in the form of higher prices.
This spiral persisted until the Federal Reserve, under Paul Volcker, intervened with aggressive monetary policy. Interest rates were raised to unprecedented levels, peaking above 20% in the early 1980s. The result was a severe recession, with unemployment climbing to over 10%. While painful, these measures ultimately broke the back of inflation and restored price stability.
The 1990s Goldilocks Economy
In contrast, the mid-1990s demonstrated that wage growth does not always lead to inflation. During this period, wages rose steadily alongside significant productivity gains driven by the widespread adoption of technology. The digital revolution allowed businesses to increase output without proportionately increasing labor costs, creating a virtuous cycle of growth without inflation.
The unemployment rate fell to 4%, yet inflation remained low, hovering around 2.5%. This period, often referred to as the “Goldilocks economy,” showed that wage growth can be sustainable when accompanied by productivity improvements and structural economic changes.
The mixed ‘November 2024’ labor market
Returning to November 2024, the labor market presents a more nuanced picture. Wage growth is robust, particularly in sectors like health care, leisure and hospitality, and government. These industries, which are often labor-intensive, face challenges in achieving productivity gains comparable to those seen in tech or manufacturing.
Meanwhile, retail trade continues to struggle, shedding jobs in the face of e-commerce expansion and automation. This uneven growth underscores the complexity of today’s labor market, where some sectors experience wage-driven inflationary pressures while others face deflationary forces from technological disruption.
The steady unemployment rate of 4.2% and slight dip in labor force participation suggest a labor market that is stable but not without its challenges. For policymakers, this mixed picture complicates the task of balancing economic growth and inflation control.
Lessons from prior Fed Policy responses
The Federal Reserve’s anticipated 0.25% rate cut at its December 2024 meeting highlights the central bank’s cautious approach. While lower rates can support job creation and economic growth, they also risk stoking inflation if wage pressures persist.
Volcker’s aggressive tightening in the 1980s offers a stark reminder of the consequences of delayed action on inflation. At the same time, the 1990s show that inflation can be managed without drastic interventions, provided wage growth aligns with productivity gains.
Today’s Fed faces a unique set of challenges, including the lingering effects of supply chain disruptions, geopolitical uncertainties, and evolving labor market dynamics. Striking the right balance will require careful calibration of monetary policy and a willingness to adapt to changing conditions.
A bit of global context
The risks and realities of wage-price spirals vary across countries. Japan, for example, has struggled with low inflation despite moderate wage growth, owing to structural factors like an aging population and a deflationary mindset. In contrast, emerging markets like Brazil have often seen wage-driven inflation exacerbate economic instability, highlighting the importance of strong monetary policy frameworks.
The U.S., with its diverse and dynamic economy, occupies a middle ground. While the risk of a full-blown wage-price spiral remains low, certain sectors—particularly those with tight labor markets and limited productivity growth—could see localized inflationary pressures.
Productivity is the missing piece
One of the most significant variables in determining whether wage growth fuels inflation is productivity. When workers produce more output per hour, businesses can afford to pay higher wages without raising prices. However, if wage increases are not accompanied by gains in productivity, businesses must raise prices to maintain their profit margins, which can lead to inflation.
In the U.S. economy, productivity has been inconsistent in recent years. The tech-driven productivity boom of the 1990s is a distant memory, and while certain sectors like technology, finance, and manufacturing have experienced gains, others have struggled. Sectors that rely heavily on human labor, such as health care and hospitality, face particular challenges in driving productivity growth. In these industries, rising wages can be harder to offset with increased output, leading to price hikes for consumers.
Despite these challenges, there are signs that productivity may be poised for a resurgence. The ongoing adoption of artificial intelligence (AI) and automation technologies promises to enhance efficiency in various sectors, particularly in manufacturing, logistics, and even service industries like healthcare. As these technologies mature, they may help businesses better absorb rising labor costs, mitigating the inflationary pressures that typically accompany wage growth.
The key challenge for policymakers is ensuring that productivity gains are widespread across industries, not just concentrated in tech-driven sectors. Without broad-based productivity improvements, wage growth could continue to drive inflation in certain parts of the economy, even as others benefit from technological advancements.
Now, addressing the productivity-wage balance requires investments in workforce development. Educating and reskilling workers for higher-value tasks in sectors like technology, finance, and healthcare can help improve overall productivity levels. While these initiatives take time to bear fruit, they are crucial for avoiding the wage-price spiral trap seen in previous decades.
As we look at the data from November 2024, it’s clear that the U.S. economy is at a crossroads. The labor market is strong, but the relationship between wage growth and productivity remains a delicate one. Whether rising wages lead to a wage-price spiral depends largely on whether businesses can achieve the necessary productivity gains to offset higher labor costs.
What a weird and wonderful world,
