BlackRock's Weekly Market Commentary: Wage-price spiral ahead? Not really

By the BlackRock Investment Institute

U.S. wages are growing at the fastest clip since the 1980s. Is this the start of a “wage-price spiral” – a vicious cycle of companies funding higher pay by raising prices, causing employees to ask for even higher wages? We don’t think so. In reality, we find companies are paying less in labour costs per unit of output than before the pandemic thanks to higher productivity and prices. We believe wages can rise further without adding to inflation – and help normalise the labour market.

Chart of the week

U.S. labour costs, 2019-2021

Sources: BlackRock Investment Institute, with data from Haver Analytics. Notes: The chart shows the level of U.S. private wages and salaries (in pink) from the U.S. employment cost index measure of hourly labour costs. The yellow line shows this measure of wages adjusted for productivity, by dividing by the level of output per hour. The red line shows this productivity-adjusted series adjusted for inflation by dividing by the U.S. personal consumption expenditure headline price index.

Wages measured by the Employment Cost Index jumped 5% last year – the fastest pace since the 1980s (pink line in the chart). Some argue this is evidence of an overheating job market and a precursor to spikes in consumer prices. But higher wages don’t necessarily mean higher inflation. What matters for companies is the real unit labour cost: how much a company pays workers to produce a unit of output relative to that unit’s selling price. U.S. workers are 4.5% more productive than before the pandemic, according to Bureau of Labour Statistics data. Wages have actually fallen since then (the red line), after adjusting for those productivity gains (the yellow line) and higher prices. Our conclusion: Wages have room to rise as they catch up with productivity and price gains, rather than drive more inflation pressure.

How about other ostensible signs of an overheating labour market? The U.S. unemployment rate is at a pre-pandemic low. The ratio of vacancies to unemployed is at the highest level on record. We believe this is caused by a labour market still healing from the pandemic, rather than excessive demand for labour. People are quitting at record rates to improve their compensation (the “Great Renegotiation”), and the unemployed are reluctant to fill job openings. This means ballooning vacancies are a sign of people switching jobs, rather than new jobs being created. At the same time, many have left the workforce for health, lifestyle or other reasons (the “Great Resignation”). Labour force participation – the share of the working-age population with a job or actively looking for work – is 1 percentage point below its pre-pandemic level. This is very much a U.S. problem. In Europe, the quit rate is lower, and furlough programs helped participation recover quickly.

How to solve for the reduced labour supply in the U.S.? Further wage growth could entice the unemployed to fill job openings and entice employees to stay in their current jobs, rather than quit in search of better pay. Vacancies could come down and employment could rise by 1.5 million, or 1% of the U.S. work force, we estimate. And unemployment may not fall much further if higher wages induce those who left the workforce during the pandemic to return.

The labour market dynamics reinforce our belief that we are in a world shaped by supply, not excess demand. We see inflation cooling from 40-year highs as the economy heals. But we’re are not going back to the “lowflation” years before the pandemic, we believe, amid ongoing supply constraints. As a result, we expect the Fed to ultimately raise rates to a neutral level that neither stimulates nor decreases economic activity. Raising rates beyond neutral to try to squeeze out inflation even further would come at too high a cost to growth and employment, in our view. The result: We see the sum total of rate hikes at a historically low level given inflation. This reinforces our underweight to government bonds and overweight to equities. We favour developed market equities over emerging market stocks, with a preference for the U.S. and Japan over Europe. The reason: We see the energy shock emanating from Russia’s invasion of Ukraine hitting Europe hard.

Bottom line: We do not see a wage-price spiral building. Private sector wages in the U.S. have increased, but what matters for companies is that real unit labour cost have actually fallen thanks in part to productivity gains. This means there’s still room for wages to grow. Higher wages could help the U.S. labour market recover from pandemic-related worker shortages by encouraging people to return to the workforce or stay put in their jobs, rather than shopping around for more compensation.

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