Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Watching the Wage-Price Spiral
Transcript
- Lucas: If you've been watching the economic data this spring, you've probably noticed something that feels like déjà vu — the unemployment rate is at 3.8 percent, average hourly earnings are growing at 4.2 percent year-over-year, and core PCE inflation is still sitting at 2.8 percent. That combination has a lot of people in the central banking world quietly revisiting a concept from the 1960s — the wage-price spiral. Luna: Which is the idea that rising wages cause businesses to raise prices, which then forces workers to demand even higher wages, and you get this self-reinforcing loop. But a lot of economists thought that dynamic was largely broken. Lucas: Right — and whether it's actually back is one of the most consequential questions for the Fed right now. Because if the wage-price spiral is reigniting, it means the last mile of getting inflation down to 2 percent is going to be a lot harder than the first three percentage points. Lucas: Quick honest thing — a handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's literally what funds making this many of these. If walking through the economy with us has made something click, that's where you can keep it going. Luna: Yeah, no ads, no sponsors — just listener support. It's how we can spend an episode on something like the wage-price spiral and not have to rush through it. Lucas: Exactly. So — back to the spiral. The classic story comes from the 1960s Phillips Curve, where economist A.W. Phillips showed a stable trade-off: lower unemployment meant higher wage inflation. The logic made sense — tight labor markets give workers bargaining power, they demand raises, businesses pass costs on, and you get inflation. Luna: But then the 1970s happened, and that trade-off broke down. You had both high unemployment and high inflation — stagflation — which suggested the relationship wasn't as mechanical as people thought. Lucas: Right. And ever since, central banks have been skeptical of any simple wage-price link. They've focused more on inflation expectations — if consumers and businesses expect inflation to stay low, then even a tight labor market won't necessarily produce a spiral. Luna: So what's different today? Why are we even having this conversation in June 2026? Lucas: Well, look at the specific numbers. The unemployment rate has been below 4 percent for over two years now — that's the longest stretch since the late 1960s. And wage growth has been stuck in that 4 to 4.5 percent range. Meanwhile, core PCE inflation has been hovering around 2.8 percent for the past six months — it's not coming down further. Luna: And the Fed's preferred measure of inflation expectations — the Michigan survey's five-year outlook — is still right around 3 percent, which is above the 2 percent target. So you have the ingredients for a spiral: tight labor market, elevated wage growth, sticky inflation, and expectations that are a bit de-anchored. Lucas: But here's where it gets interesting. A lot of the recent research suggests that the wage-price pass-through is weaker than it was in the 1970s, partly because the economy is less unionized and more services-oriented. Also, productivity growth has been decent — around 1.5 percent annually — which can absorb some wage increases without pushing up prices. Luna: So which sectors are actually seeing the wage-price pass-through? Is it broad-based or concentrated? Lucas: That's the key question. If you dig into the data, the sectors where wages are rising fastest — healthcare, leisure and hospitality, construction — those are exactly the sectors where productivity gains are hardest to achieve. You can't automate a hotel front desk or a nursing shift. So those wage increases do tend to show up in prices. Luna: And those are also the sectors that are most sensitive to the Fed's interest rate moves? Actually, no — they're less rate-sensitive than manufacturing. So the Fed's traditional tool — raising rates — might not cool wage growth in those areas as effectively. Lucas: Exactly. That's the dilemma. The Fed can slow the economy overall, but if the wage pressure is coming from structural labor shortages — like an aging population and reduced immigration — then rate hikes might cause a recession without fixing the wage spiral. Luna: Have any central banks actually declared that a wage-price spiral is underway? Or is this still theoretical? Lucas: No major central bank has formally said it. But you can see it in their language. The Fed's May minutes noted that 'some participants' were concerned about the potential for a wage-price spiral. The European Central Bank has been talking about the need to monitor unit labor costs. And the Bank of England has specifically called out the services sector for pass-through. Luna: So they're watching it. But what would actually confirm that a spiral is happening? What's the smoking gun? Lucas: I think the smoking gun would be a sustained period where wage growth stays above 4 percent and inflation expectations start moving up. If the Michigan survey goes from 3 percent to 3.5 percent, and if you see businesses reporting that they're raising prices specifically because of labor costs — that would be the signal. Luna: There's also the question of whether the Phillips Curve has actually reflattened. Some economists argue that the curve was flat during the 2010s — low unemployment didn't produce inflation — but that it might have steepened again post-pandemic. If that's true, then the Fed may need to push unemployment higher to get inflation down. Lucas: And that's the real policy debate. The Fed's current stance is 'data-dependent,' which essentially means they're waiting to see if the wage-price link becomes concrete before acting further. But critics say that by waiting, they risk letting expectations become entrenched, which would require much more painful tightening later. Luna: So what's your read? Do you think we're in the early stages of a spiral, or is this a false alarm? Lucas: I lean toward false alarm — but cautiously. The productivity growth we've seen, plus the fact that long-term inflation expectations are still reasonably anchored, suggests that a 1970s-style spiral is unlikely. However, the risk is in the tails. If productivity slows or if energy prices spike again, that could tip the balance. Luna: And that's exactly why central banks are talking about it so much. They don't want to be caught off guard. Lucas: Right. Better to prepare for a spiral that never happens than to ignore one that does. The real challenge for the Fed in the second half of 2026 will be distinguishing between a genuine wage-price spiral and a one-time adjustment in wages that then stabilizes. Luna: And there's some interesting historical evidence. After the 2008 recession, it took years for wages to pick up, even as unemployment fell. That suggests the relationship is not stable over time — it depends on the structure of the labor market. Lucas: Exactly. So the wage-price spiral isn't a law of nature — it's a conditional outcome. And the conditions today are different from the 1970s. We have more flexible labor markets, more global competition, and better anchored expectations. But we also have an aging workforce and lower potential growth. So the jury is still out. Luna: Do you think the Fed will raise rates again this year specifically because of wage concerns? Lucas: Not based on the current data alone. But if we see another month of core PCE above 2.8 percent and wage growth accelerating, I think the odds go up significantly. The Fed has made it clear they're willing to do more if needed. Luna: So as we head into the third quarter, the labor market reports will be the ones to watch. If average hourly earnings tick up to 4.3 or 4.4 percent, that'll get the Fed's attention. Lucas: Absolutely. And it's not just the headline number. The composition matters — are wage gains concentrated in low-wage sectors where pass-through is higher? Or are they in high-productivity sectors where they can be absorbed? That granularity is what the Fed's research staff is looking at. Luna: Alright, so to sum up: the wage-price spiral is a live debate, but not a certainty. It's a risk the Fed is watching closely, with the next few months of data potentially decisive. Lucas: Yeah. And that's where we are on June 26, 2026 — waiting to see whether the last mile of inflation is a gentle slope or a steep climb.