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Putting a stop to runaway wage growth could help avoid a recession in 2023, but it will be difficult.

Strong wage growth is typically beneficial to both workers and the economy.

Now? Not at all.

According to the Federal Reserve, average pay increases are approaching the highest level in decades, fueling inflation. And this could force Fed officials to raise interest rates even further next year, potentially pushing the United States into a mild recession.

Economists believe that slowing wage growth will be critical to avoiding a recession.

But it might not be that simple.

What is the expected wage growth in 2022?

According to the Labor Department’s Employment Cost Index, average annual wage growth fell to 5.2% in the third quarter from 5.7% earlier this year. However, this is still significantly higher than the pre-pandemic average of 3.3% and about 2% in the decade preceding the health crisis.

Pay raises that are substantial are usually a good thing. However, since the COVID crisis, they have not kept pace with inflation, implying that consumers are losing purchasing power.

However, the increase in wage growth is contributing to inflation because businesses with high labour costs typically raise prices to maintain profits.

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Meanwhile, the Federal Reserve has raised interest rates sharply in order to reduce annual inflation, which reached 9.1% in June before falling to a still high 7.1% in December.

The Fed raised its key interest rate by more than four percentage points in 2022, the most since the early 1980s, and is forecasting another three-quarters of a point hike next year, to around 5.1%. Many economists believe that level will send the country into recession.

Fed Chair Jerome Powell has stated that the Fed will continue to raise interest rates until wage growth is controlled.

Why are wages increasing so rapidly?

Inflation has remained high, particularly in service industries such as restaurants and health care, as consumers shift their spending to activities such as dining out and travelling now that the pandemic has passed. This has increased demand for workers in those industries and pushed up wages. Powell stated that price increases in those industries account for more than half of a key underlying inflation measure, and that they are primarily driven by wage increases.

Labor shortages in those industries persist because millions of Americans left the workforce during the health crisis due to COVID or early retirement. Many are unlikely to return. As a result, employers must raise pay to attract a smaller pool of job candidates or entice those who have left to return.

“Wages are running…well above what would be consistent with 2% inflation (the Fed’s target),” Powell said earlier this month at a news conference. “We have a long way to go.”

“The labour market remains out of balance,” he added, “with demand significantly exceeding the supply of available workers.”

What happens when the Federal Reserve raises interest rates?

The Fed traditionally raises interest rates to raise borrowing costs, weaken the economy, and make it more expensive for businesses to hire and invest. Higher unemployment rates typically result in lower pay increases, and vice versa.

But, according to Jonathan Millar, senior U.S. economist at Barclays, the relationship between unemployment and wage growth, known as the Philips Curve, has weakened in recent decades.

Unemployment fell sharply in the decade following the Great Recession, while wages rose only modestly. This is largely because Americans came to expect low inflation for a variety of reasons and did not demand large pay raises.

As a result, according to Millar, each percentage point increase in the unemployment rate results in a quarter-point drop in wage growth. So, he claims, an 8 percentage point increase in unemployment could reduce pay gains by 2 percentage points to 3% to 3.5%. A severe recession would result from such a scenario.

Another factor that could keep wage growth elevated, according to Millar, is that job openings have fallen from a record high of 11.5 million in October of last year to 10.3 million in October of this year, which is still well above the pre-COVID level of 7 million.

Even though job growth is expected to slow as the economy loses steam next year, Millar believes that employers will still have to offer healthy raises to attract workers because there will be fewer of them.

Is US inflation decreasing?

Moody’s Analytics chief economist Mark Zandi is more upbeat. He believes that high inflation expectations, rather than worker shortages, drove wage growth during the pandemic.

Consumer prices rose as a result of record gasoline prices, supply chain issues, and Russia’s war in Ukraine, prompting workers to demand larger raises.

However, according to recent surveys, pump prices have dropped sharply and supply snags have improved, lowering consumer inflation expectations for the next 12 months.

“That should slow wage growth,” Zandi predicted.

He expects annual pay increases to fall to 4% by the end of 2023 and 3.5% by the middle of 2024, persuading the Fed to slow rate hikes as the trend becomes clear early next year.

And, he claims, this will help the economy avoid a recession.

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