March 16, 2023
We have been getting conflicting data on inflation in recent days. The February Consumer Price Index was not great, showing a one-month rise of 0.4 percent in the overall index and 0.5 percent in the core. Combined with the last couple of months’ data, it indicates a modest acceleration over the rates seen in the fall.
By contrast, the Producer Price Index came in somewhat better than expected, with the overall finished goods index declining 0.1 percent, driven by drops in food and energy prices. The core index rose a modest 0.2 percent. Most of the indices at earlier stages of production also showed a good picture. For example, the intermediate index for processed goods fell 0.4 percent in February and is now up just 2.1 percent over the last year.
The picture for import prices in February was also encouraging. The overall index for imports fell 0.1 percent in the month. Excluding fuels, the index rose 0.4 percent in February, but is still up just 0.2 percent over the last year.
The Consumer Price Index does not closely track the indexes showing the price of items at earlier stages of production, but it is difficult to envision sustained divergences. For example, the CPI new vehicle component rose 5.8 percent last year. The index for imported vehicles, parts, and engines rose 2.5 percent. These categories are not identical, but it is difficult to imagine that we would go a decade with domestic vehicle price inflation outpacing the price increases of imports by 3.3 percentage points a year.
These two indices had tracked fairly closely prior to the pandemic. For those keeping score at home, the consumer price new vehicle index has risen by 20.3 percent since the start of the pandemic. The index for imported vehicles, parts, and engines has risen by 6.8 percent, which might suggest that we can anticipate some decline in vehicle prices going forward.
The import price and producer price indices would seem to indicate that the battle with inflation has been largely won, but that is not the picture with the CPI and probably not the story in the Personal Consumption Expenditure Deflator (PCE) that we will get later this month. Fortunately, we can use wage data to get another vantage point on inflation.
Wage Growth Is Moderating
If recent months’ CPI data have given us grounds to question whether inflation is still slowing, that is not true with the most recent wage data. The annualized rate of wage growth over the last three months in the average hourly earnings series is just 3.6 percent. This is down from a peak of 6.4 percent at start of the year, as can be seen in the graph.
Source: Bureau of Labor Statistics and author’s calculations.
Furthermore, the current 3.6 percent rate is roughly consistent with the Fed’s 2.0 percent inflation target. There were several points in the two years prior to the pandemic when the pace of wage growth was this fast or higher, yet the core PCE deflator averaged less than 2.0 percent for this two-year period.
It is worth mentioning that the Employment Cost Index (ECI) shows a somewhat higher rate of wage growth, with the annualized rate for the fourth quarter coming in at 4.0 percent (actually 3.95 percent, if we want to go to a second decimal). This may be slightly more rapid than would be consistent with 2.0 percent inflation, but it’s still not clear this would be a problem.
First, there is no ambiguity about the direction of change. The ECI was rising at a 5.8 percent annual rate at the start of the year. And, by construction, there are no composition effects in the ECI, so the changing employment patterns associated with the reopening would not affect the pace of wage growth reported in this index.
The second reason why a pace of wage growth that might be slightly faster than would be consistent with 2.0 percent inflation should not be a problem, is that the Fed has quite explicitly said that 2.0 percent is an average, not a ceiling. In the decade prior to the pandemic, the rate of inflation in the core PCE averaged 1.6 percent, 0.4 percentage points below the Fed’s 2.0 percent target. While the Fed presumably would have liked to see a rate of inflation that was somewhat faster, being below 2.0 percent was not viewed as a major failing of Fed policy.
In the same vein, if the rate of inflation falls to a pace close to 2.0 percent, but still somewhat higher, say 2.4 percent, this could still be seen as consistent with the Fed’s 2.0 percent target. The key points are both that the rate of inflation is close to 2.0 percent, and that there not be a tendency for it to rise. While the definition of “close” can be debated, there is zero doubt from the wage data that the direction is downward, not upward.
This means that if price inflation follows wage inflation, we should expect inflation to be moving towards the Fed’s 2.0 percent target. The questions are: how rapidly will inflation drop and will it fall close enough to 2.0 percent for the Fed to declare victory?
Does Inflation Track Wage Growth?
Over any short period, we can see substantial divergences between the rate of inflation and the rate of wage growth. For example, inflation substantially outpaced wage growth in 2021 and the start of 2022. However, a sustained divergence would imply a continuing shift in income shares.
The gap between inflation and wage growth at the start of the pandemic was associated with a substantial increase in the profit share of national income. The before-tax profit share of national income rose from 13.1 percent in 2019 to 14.0 percent in 2021.  It edged back slightly to 13.9 percent in 2022.
If we have a view of inflation where we expect it to outpace wage growth on a sustained basis, it would imply a larger and continuing shift from wages to profits. This sort of sustained redistribution would be an extraordinary macroeconomic event. Furthermore, it is not clear that higher interest rates, designed to raise unemployment and slow wage growth, would be the best tool to reduce inflation in this context. Clearly, excessive wage growth is not the problem in this story.
Of course, the wage growth data are erratic and also subject to revision. We may be looking at a different picture when we get the March data on wages and the first quarter ECI, but based on the data we have to date, wages are growing at a pace consistent with the Fed’s 2.0 percent inflation target. This would provide a very good argument for the Fed to pause on further interest rate hikes, even if it did not have concerns about financial instability stemming from the collapse of the Silicon Valley Bank.
 The maximum and minimum were set to cut off wage growth peaks and troughs driven by changing workforce composition at the beginning and end of the pandemic shutdown period. The tighter range makes it easier to see the path of wage growth over this six-year period.
 These data are take from the Federal Reserve Board’s Financial Accounts of the United States, Table F.3, Line 7 divided by Line 1.