Will growing wage pressures keep inflation high even when supply chain bottlenecks and energy pressures are resolved?

The March 2022 Economics Spotlight examines if the current record-high inflation will persist if wage pressures continue to increase across industries.

As many of us start returning to the office, we are confronting a world that has changed—office spaces are being reconfigured to allow more physical distancing, only a fraction of our colleagues may be present on any given day as hybrid work schedules are now the norm, or our favourite prepandemic lunch spot may have disappeared. But one of the most striking changes we are all observing is how much more everything costs—from the breakfast sandwich you grabbed on the way to the office to the gas you filled up on for your commute. But it is not just prices related to “return to work” that are rising; the price increases are broad-based. In January 2022, headline inflation rose to 7.5% year over year, the highest on record since February 1982, with all categories, outside of those related to medical care, experiencing substantial price increases.1

The causes of the price increases are many, including supply chain disruptions, rising energy prices, and unanticipated jumps in demand causing supplies of various inputs to fall short. As businesses struggle to adapt to a reopening economy, one additional factor they are struggling with is finding the workers they need. With job openings at record highs, businesses across almost every industry are coping by raising wages at rates far surpassing the prepandemic norm to retain their workforces and attract new workers. While workers are no doubt pleased with receiving more pay, they are also looking at the rate at which prices are rising and wondering if their next pay increase will provide them with the same, if not more, purchasing power.

Looking forward, we expect most supply chain issues to resolve themselves as inputs align with demand. However, the outlook for labour markets is not quite clear since increasing labour supply is not as straightforward as, say, increasing the production of semiconductors. For the current situation not to devolve into “wage-push” inflation will require labour productivity to improve. Fortunately, businesses have been investing heavily in information equipment and software that may prevent that from happening.2

Some prices rose faster than others in the postpandemic economy

The recent bout of high inflation has been driven primarily by a rise in the price of durable and nondurable goods—with the services sector being much less of a contributor. Goods inflation accelerated in 2021, while prices of services have been relatively muted.

The current drivers of inflation are unusual because in the years prior to the pandemic, price increases were skewed toward services. Between 2016 and 2019, services inflation averaged 2.7% per year and grew at a faster rate than the overall price level (1.9%) (figure 1). Prices of services were largely driven by the higher cost of medical care services and shelter prices.3 This contrasts with durables inflation, where prices decreased during this period (–1%). Prices of nondurables, on the other hand, edged up 1% prior to the pandemic. However, much of the behaviour of prices for nondurable goods are determined by food and energy prices, which tend to fluctuate from time to time.

After vaccines became widely available in the first half of 2021, a rebound ensued in consumer and business demand. In the United States, this rebound was mainly concentrated in the demand for goods rather than services as virtual work became the new norm. The emergence of the Delta and Omicron variants in the latter half of the year further decreased the likelihood that many businesses would return to prepandemic work behaviours.

As the demand for durables and nondurables surged last year, household spending on goods soared 20% above the prepandemic level by May 2021. Spending on durables jumped 33% and nondurables spending increased by 13.5%. Spending on services, on the other hand, was down 0.8% during this period. Businesses found it difficult to ramp up goods production quickly, and the slowdown in manufacturing activity in Asia around the same time contributed to stress on supply chains. The result was a sharp increase in overall inflation, led by higher prices of goods. Durables inflation over the 12-month period accelerated to 18% in January 2022 from 10% in May. In contrast, prices of services rose at an annual rate of 3.1% in May and 4.6% last month (figure 2).

Wages have risen across goods and services-producing industries since 2021, contributing to inflationary pressure

Prior to the pandemic, wage increases among industries varied in a very narrow band. Goods industries recorded an increase of 2.6% in hourly earnings during 2016–2019 (figure 3). Even within the goods industries, increases in hourly earnings ranged between 2%–3%. Meanwhile, service industries saw a slightly higher increase of 2.9% in hourly earnings during this period. Industries with high wage increases included food service and drinking places and information. Industries that saw smaller wage increases included mining and logging, and transportation and warehousing. In all cases, the average wage increases exceeded overall price spikes (1.9%).

Figure 3 also shows that goods-producing industries did not have strong wage growth in 2020, but wages rose substantially in 2021. For example, manufacturing and construction industries recorded more than 5% increases in hourly earnings. Services-producing industries, on the other hand, saw high wage growth in both 2020 and 2021. Also, within services, wage increases in 2020 were concentrated in a handful of low-wage industries, such as retail trade, arts, entertainment, and recreation. Meanwhile, in 2021, wage increases have broadened to nearly every services-related industry.

Even with these high wage increases, inflation is rising higher (7.5% year over year in January 2022). Only in three services-related industries—accommodation, food services and drinking places, and couriers and messengers—have real wages risen higher than overall consumer prices.

What do current wage and employment trends tell us about future inflationary pressures?

Wages tend to be a major cost of doing business. In goods-producing industries, employee compensation makes up 20.5% of the value added to gross output; for services, the proportion is approximately 30%.4 For some industries, the role of employee compensation to value-added in gross output is substantially higher—and these industries are among the fastest rebounding in terms of employment. Between January 2021 and January 2022, the top two industries with the fastest increases in employment were food services and drinking places and professional and business services. In food services and drinking places, employee compensation accounted for more than a third of value added to gross output (36.3% in 2019), while in professional and businesses services, employee compensation constituted 45.6%.5 With employment increasing most rapidly in industries where employee compensation makes up such a large part of gross output, very high wage increases will have a disproportionally high impact on overall prices if these industries are willing and able to pass along the higher costs to their customers and clients.

As individual firms continue to grapple with the problem of sizing wage increases to attract and retain the talent they need, will this set off a wage-price spiral that will entrench inflationary expectations? Not necessarily. One additional piece is needed to determine how the inflation puzzle looks—labour productivity. Productivity growth allows the economy to maintain stable prices even in the face of higher wages so long as the productivity gains offset higher unit labour costs. Real output per hour of all persons, a measure of nonfarm business productivity, has been stronger during the postpandemic period than it was prepandemic, although not strong enough to offset wage increases. Productivity increased 1.9% in 2021, while unit labour cost rose 3.5%.6 If the investments that businesses have been making in categories such as information-processing equipment and software cause future productivity growth to rise sufficiently to offset wage increases, then wage increases can be easily supported without pushing up unit labour costs.

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  1. Bureau of Labor Statistics (BLS) data via Haver Analytics, accessed February 2022. Unless otherwise stated, all data is sourced from Haver Analytics.

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  2. Daniel Bachman, Is the writing on the wall for buildings? Business investment since COVID-19, Deloitte Insights, January 28, 2022.

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  3. The BLS classifies shelter as a service: “Shelter, the service that housing units provide their occupants, is a major part of the CPI market basket—the goods and services that people need for day-to-day living. Two CPI indexes, Owners’ equivalent rent of primary residence (OER) and Rent of primary residence (Rent), measure the change in the shelter cost consumers receive from their primary residences.

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  4. Bureau of Economic Analysis, “Gross output by industry,” accessed February 2022.

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  5. Ibid.

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  6. BLS data.

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Cover image by: Jaime Austin

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