IE 11 is not supported. For an optimal experience visit our site on another browser.

Wage slashing is not the answer to inflation

No matter what you've heard, employees wanting better pay isn't pushing up costs.

The Federal Reserve on Wednesday raised interest rates the sixth time this year in its bid to get inflation under control. Economists are still disentangling what factors caused the rise in inflation over the last two years and what factors exacerbated it — but what is clear is that as voters have weathered higher costs for basic necessities like groceries and gasoline, the general public’s dislike of inflation has become a leading issue in the midterm elections.

For the government to be able to reduce inflation, two pieces of knowledge are necessary to understand: which primary causes can be addressed through policymaking and what will improve standards of living and economic stability without eventually worsening inflation. Unfortunately, this knowledge can be hard to come by as researchers are still analyzing how the pandemic rocked the economy.

In the absence of that data, one all too common theory is that rising wages create a reinforcing dynamic called a wage-price spiral. The story goes: When wages increase, consumer demand increases because workers have more income. That new demand increases prices, which necessitates higher wages to match price increases, creating a cycle that sustains inflationary pressure. Despite Federal Reserve Chair Jerome Powell himself stating, "I don't think wages are the principal story for why prices are going up," at Wednesday’s news conference, this narrative is echoed by politicians and business leaders alike — but economic evidence shows us this is more fiction than fact.

One all too common theory is that rising wages create a reinforcing dynamic called a wage-price spiral.

Underlying this myth is the idea that workers can successfully bargain for higher wages because they face higher costs of living — but we know that this is not the labor market most workers face. Income inequality has been rising over the past 40 years as union density has declined. The wage-price spiral theory depends on workers winning higher wages without collective bargaining rights. But Fed researchers have seen a relative shift away from worker power as one of the major drivers of inflation.

Domestic outsourcing, where workers are employed by a subcontractor so they cannot directly bargain over the split of revenue in their workplaces, has also short-circuited a traditional source of compensation and efficiency gains. Simultaneously, previous norms about fairness within firms have diminished in workplaces with multiple employers, like, for example, a company that hires custodial workers under a janitorial services contractor. The custodian is not technically the co-worker of those whose offices they clean; they have no upward career ladder within their physical workplace. This has reinforced overall income inequality and led to CEO pay rising to 350 times what an average worker is paid. Meanwhile, the economy has kept growing, but most workers just have not shared in the value they create.

The truth is that most workers cannot simply demand higher wages in response to inflation. Consider the difference between two hiring scenarios: wage posting and wage bargaining. Under wage posting, a worker must accept a posted wage for a job (i.e., take it or leave it); under wage bargaining, they can negotiate with their employer over their wages. Research has found that low-income workers facing better job prospects elsewhere aren’t able to bargain for higher wages in their current job — they either stay at a lower wage or they quit. (High turnover from workers quitting has high costs for companies too.) Only workers in the highest quarter of the wage distribution appear to be able to negotiate for higher wages in their current jobs.

This matters for the wage-price spiral story because higher-income workers save more of their income as their salary increases. Meanwhile, lower-income workers comparatively see their demand as consumers increase along with wage increases. (Economists chart this as the marginal propensity to consume: how much of each additional dollar is used for consumption versus savings or investment.) So even where workers can bargain for higher wages, we’d expect it to have a lesser impact any upward pressure on prices.

There is no strong evidence that points to a wage-price spiral causing today’s inflation.

Further, there is no strong evidence that points to a wage-price spiral causing today’s inflation. Simple correlations have found no relationship between the sectors with the most wage growth and where costs are going up the most. In fact, when the Bureau of Labor Statistics released its Employment Cost Index last week, wage growth was found to be decelerating. And this is reflected in other economic data about the financial health of average working people in the U.S., with household debt now above its pre-pandemic levels.

In fact, there is mounting evidence that workers are actually still underpaid compared to the value they contribute to economic growth, leading to lost potential in the economy. When wages are suppressed from employers exercising their market power — a phenomenon known as monopsony — then employment levels in the economy also tend to be suppressed. One study found that the opening of a big employer like a Walmart Supercenter led to an aggregate decrease in both earnings and employment within a county in the subsequent five years. When wages were increased at the bottom of the income distribution within a county from minimum wage levels, earnings and employment came back up across the board.

Ultimately, wages are being held lower than what would be predicted in a competitive economy. With workers strapped amid high inflation, now is certainly not the time to further push wages down. It has become increasingly clear that the wage-price spiral is — at best — a convenient misunderstanding for those who benefit from sustained levels of income inequality. Hopefully, the members of Congress who take their seats following next week’s elections will start to listen to the evidence — because the well-being of workers, and our country’s economic growth, cannot afford using myths as a driver for economic policy.