The answer to this question depends entirely on how one defines “cause”. There’s a sense in which wages do not cause inflation, and an equally plausible sense in which wages do cause inflation. I’ll begin with the negative view, by responding to a recent FT story:

The Fed expects the labour market to cool this year, but it believes that — unlike in the past — a sharp rise in unemployment will not be necessary to bring inflation to their 2 per cent goal. One reason why is a big influx of foreign workers into the US, helping to contain wage growth and, ultimately, prices.

While immigration has become a politically charged topic, with lawmakers on the Hill locked in a months-long debate over migrants entering the country via Mexico, the impact of a post-pandemic wave of new arrivals has been positive for the US economy.

The Congressional Budget Office, Congress’s independent watchdog, said on Wednesday that the wave would boost output by $7tn over the next 10 years, with the US labour force likely to have 5.2mn more people by 2033 compared with estimates taken in February 2023.

The phrase “contain wage growth and, ultimately, prices” suggests that causation goes from slower wage growth to slower inflation.  Perhaps people are thinking in microeconomic terms; how would an individual firm react to higher wages?  At that level, it really does make sense to speak of wages driving prices higher, as in the case where a restaurant must pay its workers $20/hour instead of $10/hour.  

Unfortunately, it’s dangerous to use microeconomic analogies in macro.  For instance, borrowing costs are also important to many businesses.  If firms must pay higher rates to borrow money to finance inventories, then they will have an increased cost of doing business.  But does that mean that the Fed can reduce inflation by reducing interest rates?  Obviously, things are not that simple.  The fallacy of composition says that what’s true for the individual firm may not be true for the economy as a whole.

In fact, higher wages probably do not “ultimately” cause higher inflation in the sense that most people view causality:

Wages —-> Prices

Instead, both wage and price inflation are driven by the third factor:

Monetary policy —-> Nominal GDP growth —-> Wages & Prices

So if someone tells me they don’t believe wages cause inflation, I won’t disagree.

On the other hand, if someone tells me that lower wages will lead to lower inflation, I won’t disagree with that either.  There is a sense in which lower wages lead to lower inflation.

The Fed has a dual mandate, stable prices and high employment.  You can think of wage moderation as a factor that allows the Fed to bring down inflation without creating high unemployment.  In a technical sense, it’s a tight money policy that slows NGDP growth that ultimately causes lower wage and price inflation.  But downward wage flexibility makes the Fed more willing to undertake that policy.

So what’s the most likely source of the wage moderation?  There seems to have been a surge in immigration, which has boosted both labor force growth and real GDP growth.  Because of this extra supply of labor, nominal wages are growing less rapidly than otherwise.  And the faster RGDP growth means lower price inflation for any given NGDP growth rate.

That italicized qualification is essential.  I am not saying that faster RGDP growth causes lower inflation.  That would be reasoning from a quantity change.  Rather, faster RGDP growth for any given NGDP (i.e. any given aggregate demand) leads to lower inflation.  But of course there is only one way that RGDP growth can rise if NGDP growth is stable—a positive aggregate supply shock.  And that’s what we’ve had in 2023.

To be clear, I am not suggesting that all’s well and that we now have a soft landing.  Today’s disappointing CPI report supports the claims made by those of us worried about the difficulty of achieving the “last mile” of inflation reduction.  But the immigration surge has certainly made a soft landing somewhat more plausible than before.  Now the Fed needs to finish its job and get NGDP growth back down to about 4%.

PS.  Whenever I do a wage post, people confuse real and nominal wages.  Nothing in this post has any bearing on the issue of whether higher real wages are desirable.  Personally, I’d love to see workers get much higher real wages.  My focus here is the completely unrelated concept of nominal wage growth, which needs to slow in 2024 from the excessive rate of 2023.