Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / How Wages Are Rising Without Adding to Inflation
Transcript
- Lucas: Average hourly earnings just hit $37.50. That's up nine cents from the previous month, which doesn't sound like much, but annualised it's about three percent growth. And here's the thing — core PCE inflation is sitting at 3.4 percent. So we've got wages rising at a healthy clip, inflation still above the Fed's target, and yet the two aren't spiralling the way economists used to expect. Luna: Right, the classic wage-price spiral theory says rising wages should feed into higher prices, which then push wages up further. So why isn't that happening now? Lucas: That's the million-dollar question. The key variable that a lot of people overlook is productivity. If workers are producing more per hour, employers can afford to pay them more without needing to raise prices. And we've actually seen a decent productivity bump over the past year and a half — nonfarm business productivity grew at about a two percent annual rate in the first quarter. Luna: So the idea is that wage increases are being absorbed by efficiency gains, not passed through to consumers. But is that story holding up across the whole economy? Lucas: Not uniformly. In goods-producing sectors like manufacturing, productivity gains have been strong — automation, better supply chain management post-pandemic. But in services, especially low-wage services like hospitality and healthcare, productivity growth has been much weaker. Yet those are exactly the sectors where wage pressures are most intense. Luna: So we have a split economy — one part where wage growth is justified by productivity, and another part where it's not. That second part sounds like it should worry the Fed. Lucas: It does, but there's another layer. Look at where the inflation actually is. Core PCE at 3.4 percent — that's still heavily driven by shelter costs and a few sticky service categories like auto insurance and medical care. Those aren't directly tied to wage growth in the way that, say, a restaurant raising menu prices to cover higher staff pay would be. Luna: Shelter is its own beast. And the Fed's preferred measure, PCE, weights things differently than CPI. So the headline inflation number might be masking a more benign wage-price dynamic. Lucas: Exactly. If you strip out shelter, core PCE is closer to two and a half percent. Still above target, but not alarmingly so. And wage growth in the industries that are actually driving inflation — like tech and professional services — has actually moderated. The big wage increases are in leisure and hospitality, but those sectors have a smaller weight in the PCE basket. Luna: That's a really important distinction. So the wage growth that's happening isn't in the places that would most directly feed into the inflation the Fed is tracking. That could explain why the Fed hasn't felt the need to hike rates further despite a tight labor market. Lucas: Right. The Fed funds rate is at 3.63 percent — they've held steady for months. And the yield curve is still inverted, with the two-year above the ten-year. That's typically a recession signal, but the economy keeps adding jobs. We added 172,000 nonfarm payrolls in May. Luna: And the unemployment rate is flat at 4.3 percent. So this is a genuinely weird moment — solid job growth, decent wage gains, sticky but not accelerating inflation, and a yield curve screaming recession. Lucas: It is weird. And it brings us back to the wage question. If wage growth can continue at around three percent without reigniting inflation, that's kind of the soft landing scenario the Fed has been aiming for. But if productivity gains fade — and there are some signs that the post-pandemic productivity boost is leveling off — then we could see unit labor costs start to push prices up again. Luna: Speaking of things that might be worth a coffee — if navigating these economic puzzles with us has made something click for you, honestly, if today was worth a coffee to you, there's a link for that. It's buy me a coffee dot com slash fexingo. No pressure at all, just a way to keep this independent and ad-free. Lucas: Yeah, that's exactly right. We love digging into these numbers, and listener support is what lets us keep doing it without any corporate sponsors. So that's buy me a coffee dot com slash fexingo if you're inclined. Luna: Back to those unit labor costs — they're the metric to watch. The Fed's dot plot last week showed they still expect one rate cut this year, but that's totally contingent on inflation continuing to cool. Unit labor costs rose at a 1.8 percent annual rate in Q1, which is manageable. If that number ticks above three percent, all bets are off. Lucas: And here's the wild card — immigration. The labor force has grown faster than expected over the past two years, partly due to immigration policy changes. That's added supply on the labor side, which helps moderate wage pressures. But it also adds demand, because those workers are also consumers. So the net effect on inflation is ambiguous. Luna: Right, more workers means more output potential, but also more spending. The CBO recently revised up its population projections, and that feeds into potential GDP estimates. If the economy's capacity to grow without overheating has increased, then the neutral rate of interest might be higher than the Fed thinks. Lucas: That's a really sophisticated point. The neutral rate — R-star — is essentially the rate that neither stimulates nor restrains the economy. If it's moved up, then the current Fed funds rate of 3.63 percent might actually be less restrictive than it appears. And that would mean wage growth could continue without the Fed needing to cut. Luna: So the wage-inflation disconnect might be telling us something deeper about the structure of the economy. Maybe we've entered a new regime where three percent wage growth and three percent inflation can coexist without spiraling, because the underlying growth rate of the economy has shifted. Lucas: That's the bull case. The bear case is that this is a temporary equilibrium that will break once the productivity tailwind fades. And we've seen some softening in capital expenditure intentions in the latest ISM survey — businesses are getting cautious. If they stop investing in automation, productivity growth slows, and then wage pressures become a real problem. Luna: So the next few months of data are crucial. If we see unit labor costs start to accelerate, that would be a red flag. But if they stay around two percent or below, the Fed can probably hold steady and let the economy grow into this new equilibrium. Lucas: Exactly. And there's one more data point I want to flag — the ten-year breakeven inflation rate is at 2.20 percent. That's the market's expectation for average inflation over the next decade. It's actually been falling slightly, from 2.21 a week ago. So bond investors are not expecting a wage-price spiral. They see inflation settling back toward two percent over time. Luna: Markets aren't always right, but they're pricing in a pretty benign outcome. And that's consistent with the idea that wage growth can be absorbed without causing lasting inflation. Lucas: Right. So the key takeaway for today is this: wage growth at $37.50 an hour is not automatically inflationary. It depends on productivity, on where in the economy that wage growth is happening, and on the broader supply-side dynamics. The data we have right now suggests we're in a sweet spot — but it's a fragile one. Luna: And the Fed is watching closely. Chair Powell's next press conference is in late July, and the market will be parsing every word for signs of a shift. If the wage data stays where it is, I think they stay on hold. Lucas: Agreed. Alright, that's The Macro Memo for today. We'll be back tomorrow with another angle on the numbers that matter. Luna: Thanks for listening, everyone.