How’s U.S. wage growth doing these days? According to the January data from the U.S. Bureau of Labor Statistics, average nominal wage growth for all U.S. workers grew at a 2.5 percent clip over the past year. Given that a decent target for healthy nominal wage growth is between 3.5 percent and 4 percent, current wage growth seems quite subpar.
Of course, when a figure is in nominal terms, that means it hasn’t been adjusted for inflation. Fudging the data a bit—because we don’t have data for January 2016 yet—inflation from December 2014 to December 2015 was 0.66 percent as measured by the Consumer Price Index. That means real (or inflation-adjusted) wage growth over the past year was about 1.8 percent. Seeing as how a healthy level of real wage growth is about 2 percent, current wage growth now seems to be pretty much on target.
So, which statistic is a better judge of labor market performance? Is wage growth subpar, or is it on target?
Most of the time when looking at wage growth, we want to focus on real, inflation-adjusted wage growth—because we don’t know how much more goods and services higher wages can buy without accounting for inflation. Nominal wage growth doesn’t mean much, in terms of boosting the purchasing power and well-being of workers, if inflation eats away at the gains. But let’s remember that inflation-adjusted wage growth is just the difference between nominal wage growth and inflation. Two percent nominal wage growth and no inflation gets you the same amount of real wage growth as 4 percent nominal wage growth and 2 percent inflation.
So why should we think that nominal wage growth is important? Well, think about the last time you asked for a raise or a new salary in inflation-adjusted terms. More likely than not, you’ve never done that. A wage rate or salary gets negotiated depending on a number of factors—and in the short term, the amount of labor market slack is a very large factor. But because most worker’s salaries are not currently indexed to inflation, compensation doesn’t get pumped up or down depending upon the amount of inflation that actually happens over the course of the year.
When you and your employer negotiate over pay, everything is set in nominal terms. Now, you both may have inflation in the back of your head as you negotiate, but you typically wouldn’t ask for a 2.6 percent raise based on last year’s CPI-U. Imagine the extra haggling over what inflation index you’d use! Instead you negotiate with your expectation of future inflation in mind.
That’s why the target for nominal wage growth accounts for the level of inflation we’d expect in a healthy economy: 2 percent, which is the Federal Reserve’s target. If you add the expected longer-run trend in labor productivity (1.5 percent to 2 percent), then you get a wage growth rate consistent with a stable share of income going to labor: 3.5 percent to 4 percent.
And while inflation may be closer to zero right now than the Federal Reserve’s 2 percent target, we’re not so sure how much longer that will be true. A big chunk of the low levels of inflation in the United States right now is due to the massive decline in the price of oil. The drop in oil prices is definitely a gain for the increased purchasing power of workers, but this increase in real wage growth doesn’t mean the labor market suddenly got stronger.
And what if inflation does stay lower permanently, so that workers and employers expect, say, 0.5 percent annual inflation? At first, this is great news for wage earners: You’re getting nominal wage growth of 2.5 percent and inflation is 0.5 percent, so real wages are going up 2 percent. But eventually this information is going to trickle into wage negotiations and push down the nominal wage growth consistent with previous negotiations. Your employer may think, “I would have given him a 3.5 percent raise back when inflation was 2 percent, but now that inflation is 0.5 percent his raise is going to be 2 percent.” Your real wage increase for the next year—assuming inflation stays at its new 0.5 percent annual rate—is 1.5 percent. And this process will continue over the years until the new level of inflation gets fully processed. (Josh Bivens of the Economic Policy Institute makes a similar point here.)
So here are the options: Either near-zero inflation is a transitory problem that is temporarily masking a weak labor market, or lower inflation expectations will eventually cause nominal wages to also decline, meaning the stronger real wage gains are illusionary. The stronger real wage gains of the past year or so are nice, but we shouldn’t act like they are going to stick around forever