Real Wages Up with More Room to Grow

Today's CPI report came in a tick above expectations, as headline prices for September increased 0.2% and core prices increased 0.3% (expectations were for 0.1% and 0.2%, respectively). On a yearly basis, headline inflation fell for the sixth straight month to 2.4%, down from 3.7% a year ago and the lowest since February 2021. Yearly core inflation ticked up to 3.3%, although it is still down from 3.8% and 4.1% six and twelve months ago.

See today's X thread for more details on the report.

Falling inflation has been a welcome development for many reasons, but one of the clearest ways to see the benefits is in terms of real, or inflation-adjusted, wage growth. Table 1 shows that going back two years to September 2022, nominal yearly wage growth was a strong 5.1%. But inflation was almost 3 percentage points faster, leading to falling real wages, down 2.8%. Wage growth slowed to 4.5% the next year (September 2023), but inflation slowed even more, leading to a real wage gain of just under 1%. Last month, inflation was down to 2.4% with nominal wage growth at 4%, leading to a solid real gain of 1.5%.

The last line of the table shows that over the last two years, wage growth has slowed by about 1.2 p.p.t. while inflation has slowed by a much larger 6 p.p.t., leading to a 4.3 p.p.t. acceleration of real wages. The main factors behind these developments are the persistently strong labor market and the equally persistent trend in disinflation. The result is workers' paychecks with more buying power.

It is a standard finding in labor economics that tighter labor markets don't just drive benefits like those in Table 1, but that persistently low unemployment disproportionately helps lower-paid workers, thereby helping to reduce wage inequality. Figure 1 shows industries sorted by their average wages in 2019 (horizontal axis) and their subsequent wage growth through September 2024. Workers in industries with the lowest initial average wage saw the biggest percent gains over the last five years. For example, restaurant and hotel workers in the leisure and hospitality sector saw a nearly 35% cumulative increase in wages, starting from the lowest base of about $17 dollars. At the other end of the figure, workers in information (for example, workers in the broadcasting industry) and utilities had the highest starting wage and saw a more modest increase.

CEA believes there is considerable room for real wages to keep growing, both for lower-wage workers and for workers overall, all while inflation continues to ease towards its 2% target.[1]

A big reason for that belief is that workers' share of national income took a hit during the pandemic inflation, a trend that is even more pronounced after a recent data revision found that productivity and national income are up more than previously believed. Figure 2 shows the recent movement in labor share, incorporating that revision. The labor share is an important indicator of how the economic pie is divided and examining its movements helps relate compensation growth to other macroeconomic variables.

[1] This refers to the Federal Reserve's 2% inflation target.

For example, economists believe that nominal compensation growth of around 3.5% is consistent with trend productivity growth of about 1.5% and inflation of 2%. However, this is predicated on a constant labor share, as the following simple identity shows:

The labor share in 2019 - which was consistent with low and stable inflation - was a bit more than one percentage point higher than it is now. Simply raising the labor share one percentage point-close to its 2019 level-would take an additional 2 percentage points rise in nominal wages above productivity and inflation (because a one percentage point rise in the labor share from 52 to 53 percent is equivalent to a roughly 2% increase). Spread over the next four years (for example), this would mean roughly an additional 0.5 percentage point in year-over-year growth beyond the 3.5 percent nominal rate that is typically assumed to be consistent with target inflation.

Even this calculation is conservative in the sense that productivity growth has recently been much stronger than 1.5 percent, clocking in at about 2.4 percent in the last four quarters and 2 percent over the last eight (through 24Q2). With higher productivity growth, wage growth can be even stronger without igniting above-target inflation (instead of 1.5% productivity plus 2% inflation, we have, e.g., 2% productivity plus 2% inflation). Of course, the future path of productivity is uncertain, and it is entirely possible that productivity growth returns to its longer-run trend of roughly 1.5 percent.

In sum, because inflation has eased more than nominal wage growth, real wages are up strongly over the past few years, providing workers with a bit more buying power and therefore, breathing room. CEA will continue to monitor these important trends.

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