The U.S. economy has demonstrated amazing flexibility and resiliency since the pandemic recovery cycle began three years ago. In the second quarter of 2023, real growth expanded by 2.4%, while business output expanded by 2.7%.
Meanwhile, business productivity jumped by 3.7% and unit-labor costs rose a subdued 1.6%. At the same time, overall prices increased by 2.2% — well within the U.S. Federal Reserve’s target and the lowest inflation rate since the second quarter of 2020.
Yet the Fed punished the U.S. economy further with another interest-rate hike on July 26. This is equivalent to giving your top student a failing grade, anticipating that despite top marks so far in the semester, you anticipate for some obscure reason that his or her performance will soon decline.
What jumps out as a powerful empirical trend over extended periods, real labor compensation — or the “real” standard of living adjusted for the rise in prices — generally rises in line with productivity trends. This not only ensures an equitable distribution of income, but productivity also generates higher prosperity.
The wage-inflation presumption holds only if the growth of labor compensation exceeds the growth of prices and productivity. Or, equivalently, if “real” wages exceed the growth rate of productivity, in which case the income share of labor compensation would increase. Yet U.S. economic history since World War II presents no evidence to support this.
- Key trends in the U.S. business sector: 1947- 2023
To understand today’s environment, it’s informative to highlight three distinct postwar periods in the U.S., based on a structural break in inflation trends in 1982 — about three years after Paul Volcker was appointed chair of the Fed in 1979.
Inflation, after a brief acceleration related to the Korean War, stayed low through most of the 1960s. Inflation began flaring up in 1968 and remained high until 1982.
The growth of real wages trailed behind the growth of productivity. A portion of this gap is due to alternative measures of prices, but after adjustment, labor compensation as a share of business-sector GDP fell by a cumulative 2 percentage points. Thus, there is no evidence of wage inflation during this period.
- A general trend of disinflation: 1982-2019
In this period, there’s even less evidence of wage inflation. The growth of real wages again trailed the growth of productivity. Labor compensation as a share of income declined by a cumulative 6 percentage points.
- The pandemic cycle: 2019-2023
Due to the pro-cyclical nature of productivity, there was a burst of productivity early in the pandemic cycle through the end of 2021. When the U.S. economy slowed in 2022 — a classic mid-cycle slowdown — productivity slumped for five consecutive quarters then rebounded by 3.7% in the second quarter of this year.
The growth of real wages tracked the growth of productivity fairly closely, but the share of labor compensation in business GDP edged down by about a percentage point. There’s no evidence of wage inflation during the pandemic cycle either.
The clear conclusion is that there’s been no evidence of wage inflation since the end of World War II. If anything, the evidence points to gradual, progressive wage deflation.
If there’s been no wage inflation during the pandemic cycle, then what has caused the surge in inflation that peaked in the first half of 2022? Contributors include sharp increases in the prices of energy, electricity, semiconductors, grains and other products, exacerbated by post-pandemic supply chain brittleness and the outbreak of the war in Ukraine.
U.S. corporate profit margins also increased. In other words, there was “profitflation” — also known as “greedflation.” The ability of industry to raise prices aggressively, rather than defensively, is tied to increasing business consolidation and more mergers and acquisitions. Indeed, bank takeovers resurfaced in the first half of 2023 under severe liquidity stresses created by higher short-term interest rates; that story is not yet over.
Read more: Greedflation is not letting up. Here’s what companies are saying about it.
Looking ahead
The empirical regularities reported here do not support the wage-inflation myth. But how might these generally positive long-term trends reverse? If there was a significant and persistent slowdown in overall growth, that would negatively impact productivity. Ironically, this is exactly the kind of “slow growth, higher unemployment” path for the economy that the Federal Reserve is attempting to engineer.
Productivity is strongly “pro-cyclical” — it increases during the early phases of expansions and then flattens out or declines during mid-cycle slowdowns and the latter phases of the business cycle.
If the Fed’s inflation target is an aggressive 2% and productivity reverses course in the next 12 months due to the Fed’s pumping rates even higher, then to avoid wage inflation, wage growth would have to slow abruptly. No wonder Fed Chair Jerome Powell’s string of worry beads keeps getting longer.
A high real interest-rate, slow-growth scenario would have further negative impacts on business investment and expenditure on R&D, both of which are also strongly pro-cyclical. This is a recipe for a combination of stagflation and “stag-innovation.”
Focusing on the post-2005 period, there is a high probability that U.S. businesses can churn out productivity gains with growth near 2.5%, or higher. Conversely, there is a low probability of productivity gains if growth struggles in the range of 1% to 2.25%, or lower. A more constructive scenario for general disinflation over the next two years would be nominal U.S. GDP growth of around 5%, with both real growth and inflation at 2.5%, nominal wage growth at 3.5%, and productivity averaging near 1%.
This gradualist approach builds constructively on recent disinflation trends. Shelter costs — or “owners’ equivalent rent” — remain the single main contributor to inflation. Inflation excluding shelter costs declined to 1.4% in June 2023, and core inflation, excluding food, energy and shelter, declined to 2.3%.
Not counting problematic shelter costs, the disinflation battle has been won. Consumer sentiment rebounded in July 2023 and market inflation expectations have declined over the past year to near-2%.
Are we going to throw out the productivity baby with the shelter-costs bathwater?
Pressure on shelter costs is related to limited developable land, regulation hurdles and delays, ascending local fees and taxes, and the constrained supply of trades and construction workers.
Innovative solutions are needed. “Productivity-innovation” disinflation would reverse negative business sentiment, shift a portion of profits from massive, risk-averse and riskless stock buybacks back to productive business investment and R&D.
It’s long overdue to let go of the wage-inflation myth and focus on productivity potential. The resources are at our fingertips; it’s a matter of applying fresh insight, vision and leadership.
Brian Bethune is an economics professor at Boston College.
