Workers Expect Fast Inflation Next Year. Could That Make It a Reality?

Amitis Oskoui, a consultant who works mostly with nonprofits and philanthropies, has not had a wage increase since inflation began to noticeably eat away at her paycheck early this year. What she has had are job offers.

Ms. Oskoui, 36, has tried to leverage those prospects to argue for a raise as the rising cost of food, child care and life in general in Orange County, Calif., has cut into her family budget.

“Generally, in the past, it was taboo to say: I need it to survive, and I know what I’m worth on the market,” she said. “In this environment, I think it’s more acceptable. Inflation is so front of mind, and it’s a big part of the public conversation about the economy.”

That logic, reasonable at an individual level, is making the Federal Reserve nervous as it echoes across America.

When employees successfully push for raises to cover their cost of living, companies face higher wage bills. To offset those expenses, firms may lift prices, creating a cycle in which fast inflation today begets fast — and maybe even faster — inflation tomorrow.

So far, Fed officials do not think that wage growth has been a primary driver of America’s rapid inflation, Jerome H. Powell, the Fed chair, said on Wednesday.

Fresh data out on Friday showed that average hourly earnings climbed 4.7 percent over the past year. That is far faster than the 3 percent pace that prevailed before the pandemic, and is so quick that it could make it difficult for inflation to fully fade. Plus, policymakers remain anxious that today’s pressures could yet turn into a spiral in which wages and prices chase each other higher.

If that happened, it could make inflation agonizingly difficult to stamp out — a major reason the Fed is adjusting its policy rapidly. Central bankers raised interest rates three-quarters of a point this week and signaled that they would lift them further in an effort to slow the economy and wrestle price increases down quickly enough to curb inflation expectations.

Some measures of short-term inflation expectations have picked up recently, meaning that people assume prices will continue to go up, at least for a while. That “may be important in the wage-setting process — there’s a school of thought that believes that,” Mr. Powell said this week. “So that’s very concerning.”

Economists typically focus on longer-term inflation expectations, because short-term expectations jump around a lot in response to gas and food prices, which are volatile. Those longer-term measures offer more encouraging news: They remain low across a number of survey-based measures even after 18 months of rapid inflation.

But, as Mr. Powell alluded to, some economists think short-term inflation expectations could influence what workers ask for during pay negotiations. When people see everyday prices rising, they may want to cover those expenses even if they believe that inflation will simmer down over the long run.

“With inflation as high as it is, it’s very much on people’s minds,” said Karen Dynan, a Harvard economist. When it comes to short-term expectations as a wage driver, she said, Mr. Powell is “right to be looking at it: There’s a fundamental logic to it.”

That’s why recent trends in short-term expectations are at least somewhat worrying. Since late summer, some measures of short-term inflation expectations have edged up, and even those that haven’t remain very elevated.

In one survey of global employers that the insurance advisory firm WTW released this summer, 47 percent of those that were increasing pay more than they had initially expected in 2022 said they were responding to worker concerns and expectations.

Workers anecdotally report asking for more pay because of their rising costs. Ms. Oskoui, who moved to California from New York during the pandemic to be close to family, expects to receive a wage increase this year — perhaps 5 percent. But that would not be as big a move as she would like.

People like Ms. Oskoui have a good chance of earning more if they leave their employers. The job market is abnormally strong, with plentiful openings and scarce applicants, and the gap between how much wages are growing for people who leave their jobs and those who stay is unusually big: 7.1 percent versus 5.2 percent, based on the Atlanta Fed’s latest wage-growth tracker data.

That is where the Fed’s policy tools could prevent wage-induced inflation from taking hold more firmly. The central bank expects that by constraining economic demand and slowing down the economy, its higher interest rates will eventually push the unemployment rate up. With more people out of jobs and applying to work, employers can compete less, and employees will have a more difficult time winning big pay bumps.

That’s likely to be a painful process for workers — something Fed officials acknowledge. But they argue that it would be even worse to allow inflation to climb for such a long time that it became a key part of how future wages and prices were set. Once inflation is entrenched, pulling it back down might require an even bigger falloff in demand and a larger spike in unemployment.

Part of the challenge is that nobody knows exactly when inflation will go from temporary to embedded. Economists do not understand inflation all that well: They regularly disagree about whether expectations matter at all, which ones are important and why. Models based on historical data may offer little guidance for today.

“We don’t have a clearly identified, scientific way of understanding at what point inflation becomes entrenched,” Mr. Powell said on Wednesday.

America does not have many recent experiences with rapid inflation. Price increases took off and seemed to feed on themselves in the 1970s, but since the 1980s they have been mostly low and stable. And today’s experience is very different from 50 years ago: Workers are less unionized, which could make it less likely that they will win higher wages in large numbers. But the population is also older and immigration is slow, which could keep pressure on employees to pay more to compete for labor.

Given the uncertainties, the Fed is focused on bringing inflation down rapidly.

“The thing we need to do from a risk management standpoint is to use our tools forcefully but thoughtfully and get inflation under control, get it down to 2 percent, get it behind us,” Mr. Powell said.

While he does not think America is in a wage-price spiral, he said, that is no reason for complacency.

“Once you see it, you’re in trouble, so we don’t want to see it,” Mr. Powell said. “We want wages to go up. We just want them to go up at a level that’s sustainable and consistent with 2 percent inflation.”

The central bank will probably debate slowing down its rate moves at its meeting in December, Mr. Powell said. But even as officials move at a moderate pace, they are likely to push borrowing costs up above the 4.6 percent level that they previously forecast, he suggested.

That aggressive path could become more of a challenge next year if economic activity and the job market begin to pull back even as inflation lingers. Yet Mr. Powell’s nod to inflation expectations this week underlines why the central bank is determined to stay the course: He thinks that economic pain now is better than lasting inflation down the road.

“He may be setting the stage to say: ‘This is why we need to stay tough,’” said Priya Misra, an interest rates strategist at TD Securities. “We don’t want them to get entrenched.”

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