Why Are Wages and Inflation Lagging?

The Disconnect Between Some of the Most Important Economic Indicators

Robert Spendlove Nov 14, 2019

The United States economy has been growing for more than 10 years now, which makes it the longest expansion in American history. Many people are benefiting from unemployment rates that are among the lowest in decades. However, wage growth for much of the economic cycle has been lower than expected. This has many economists scratching their heads, wondering why an otherwise strong economy is not resulting in stronger worker benefits. Perhaps this is a sign that the historical relationship between employment growth and wage growth is changing.

Job Growth Usually Drives Wage Growth

Traditional economic theory holds that unemployment and wages have a stable and inverse relationship. This is the result of basic supply and demand. As an economy improves, employment grows. With a limited supply of available workers, this employment growth causes unemployment to shrink. A dropping unemployment rate means employers struggle to find qualified workers. In order to attract people, businesses are forced to raise wages to remain competitive. With tightening profit margins, these businesses then need to raise prices to compensate for the increase in wages. The end result is that inflation increases.

The Current Economic Cycle

As the U.S. job market continues to grow, unemployment rates have dropped to levels not seen in nearly 50 years. While the unemployment rate topped 10% in 2010 as the nation was coming out of the Great Recession, it is now below 4%. This is below the “full employment” level, where virtually all people who are willing to work can find jobs. This trend is even more pronounced in many geographic areas and in several industries, such as the tech sector. 

However, the very low unemployment has not resulted in big wage increases. Before the last recession, wages were growing around 3.5% per year, and that was with an unemployment rate above 4%. As the jobless rate dropped below the levels from the last economic cycle, economists expected wages to exceed the levels from 10 years ago. However, for several years wages grew below the long-term average of 2.5%. They started to accelerate in 2018 but peaked in early 2019 and slowed during much of the past year. 

Inflation is similarly low. The Federal Reserve, which sets monetary policy for America, has a dual mandate from Congress to promote maximum employment (low unemployment) and stable prices (inflation). The Fed targets a 2% inflation rate. However, as low unemployment has not resulted in more pronounced wage increases, inflation has also lagged behind the Fed’s 2% goal.  

What Is Causing the Disconnect?

There are several theories about why the traditional relationship between unemployment, wages and inflation is not holding up in the current economic cycle. One is the increased automation of the economy. As firms take advantage of improved robotics and artificial intelligence, they can increase productivity with fewer workers. Another possible reason is the impact of globalization. As the world becomes more economically connected it is easier for companies to outsource jobs to other countries and bring back cheaper imports to sell in U.S. markets. This has shielded companies from higher wage pressures and has also prevented higher price increases.

Some Doing Well in the Current Cycle

While overall wage growth has been lower than expected lately, some groups are improving. Low-wage workers are seeing higher than average increases, as employers must do more to pull people off the sidelines and back into the labor force. Also, states such as Utah and Idaho, with very low unemployment rates, are seeing higher than average wage growth, as employers compete for an increasingly tight pool of workers.

The Debate Will Continue

Janet Yellen, the former chair of the Federal Reserve, referred to the current disconnect between unemployment, wages and inflation as a “mystery.” Economics is not a perfect science and circumstances are always changing. Ultimately, only time will tell whether this relationship will reemerge or whether the economy is fundamentally changing.

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