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.
READER COMMENTS
Bobster
Feb 13 2024 at 2:05pm
S&P reported that nominal GDP growth accelerated to 6.6%.
I’m not sure an extended pause by the Fed will get the job done.
Scott, why did the market appear to “get it wrong” and predicted a March cut?
Scott Sumner
Feb 13 2024 at 2:19pm
“Scott, why did the market appear to “get it wrong” and predicted a March cut?”
In a sense, the market always gets it wrong—as every change in market prices is a repudiation of the previous market price.
The market is continually responding to new information. With recent data suggesting higher inflation and wage growth, markets are reducing their expectations of rate cuts.
John Hall
Feb 13 2024 at 2:30pm
It’s interesting that in the monthly data for 2021 the increases in wages were roughly simultaneous with the increases in core inflation. Not a lot of upward wage stickiness.
Scott Sumner
Feb 13 2024 at 9:29pm
I think that’s partly Covid, which caused a severe labor shortage. In some cases, wages do lag prices.
John Hall
Feb 14 2024 at 9:02am
Unemployment was still above 6% in Q1 2021. The labor tightness indicator in the 2023 Benigno & Eggertsson non-linear Phillips curve paper doesn’t signal tightness until May 2021 (about two months after the third and final COVID stimulus measure) and doesn’t really start showing big signs of tightness until Q4 2021.
Scott Sumner
Feb 14 2024 at 3:14pm
There are also severe composition problems in measuring wage inflation during Covid. Low wage workers were disproportionately laid off and then disproportionately rehired.
John Hall
Feb 16 2024 at 8:14am
Good point. ECI tended to be a better measure of wage compensation during that period.
Matthias
Feb 14 2024 at 3:00am
I guess you can say that immigration can contain inflation?
That’s assuming that the money supply per capita drives the price level. If immigration is bigger than the central bank expected, inflation would be lower than otherwise?
Scott Sumner
Feb 14 2024 at 3:12pm
It depends how the government responds to the immigration. It didn’t work in the 1970s.
Thomas L Hutcheson
Feb 14 2024 at 6:14pm
But downward wage flexibility makes the Fed more willing to undertake that [disinflationary] policy.
Increased downward flexibility of ANY price in the economy reduces the income maximizing rate of inflation.
The focus on wages (as if labor were a homogeneous service) as the only relative price relative to goods & non-factor services (as if GDP was a single homogeneous good) is a splendid way to make mistakes in monetary policy making. It leads straight to the “Phillips Curve” concept. Let’s hope the Fed has not reverted to that.
(100) The Rise and Fall(?) of the Phillips Curve (substack.com)
Tom
Feb 15 2024 at 7:55am
Scott, why do we always talk about whether wages cause inflation and rarely about whether profits cause inflation? Even if the labor share of GDP is 2/3, should not we at least talk 1/3 of the times about profit moderation? So, one could say that, in a technical sense, it’s a tight money policy that slows NGDP growth and that in turn ultimately causes lower profit inflation.
There is nothing that I disagree with the post per se, it is just the perennial emphasis on wages that irks me.
Scott Sumner
Feb 15 2024 at 12:31pm
I see lots of talk about whether profits cause inflation, right up to President Biden.
derek
Feb 15 2024 at 4:46pm
Would you agree with the below?
Monetary policy —-> Nominal GDP growth —-> Prices, including the price of labor or Wage… the amount that Wages go up –> the amount of price inflation that ends up sticky (even if this is a different amount than how much wages go up).
spencer
Feb 16 2024 at 9:41am
AD = M*Vt. Unless AD expands, an increase in wages will be deflationary.
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