Pop quiz: When is fast wage growth bad news? Common sense might say the answer is “never,” as making more money is always a good thing for those on the receiving end of higher paychecks. But that viewpoint wasn’t too prominent in news coverage we reviewed when data released last week showed US wages rising 4.2% y/y in Q3, the fastest rise in over 30 years.[i] Nor have we seen much excitement amongst UK financial commentators over the prospect of soaring jobs vacancies, which employers seem to be struggling to fill, bringing higher pay. Instead, across many of the outlets we follow, the consensus viewpoint is that because rising wages followed months of above-average inflation, they are allegedly signs of a potentially brewing wage-price spiral.[ii] Meaning, a vicious cycle in which businesses raise wages to attract workers when inflation is high, then raise prices to preserve margins, fuelling more inflation, necessitating even higher wages and more price increases, lather, rinse, repeat. As logical as this might sound, however, our research shows it has little bearing in reality, and we think investors can cross it off their list of worries.
The wage-price spiral was all the rage in the 1960s after an economist named A.W. Phillips created a model showing a link between the unemployment rate and inflation. This model, now known as the Phillips Curve, has underpinned monetary policy in the US and UK for decades. It posited that when unemployment is high, businesses don’t need to raise wages to attract workers, which keeps inflation low. But when unemployment is low, according to the model, wages and inflation rise. Some Phillips Curve models use unemployment and wages, whilst others use unemployment and inflation. All hinge on wage-price spiral theory.
Nobel laureate economist Milton Friedman took this on in a 1968 speech entitled, “The Role of Monetary Policy,” which he delivered as an address to the American Economic Association. In it, he posited that the Phillips Curve was flawed because it focused on nominal wages, not real or inflation-adjusted wages. That essentially led to a model that argued inflation drives inflation, which is fatally circular. You can find his entire argument here if you are interested—it is long but thorough and clear.
Whilst Friedman covered the theoretical economic arguments nicely, we think it is also helpful to consider the wage-price spiral from a market perspective. Prices and wages don’t come out of thin air. They are determined in the marketplace, where basic economic tenets hold that they are based on supply and demand. Absent potentially misguided government intervention, the general cycle goes like this: Shortages drive prices higher; high prices send producers signals that it is time to increase supply; higher supply stabilises prices. We have already seen this play out with lumber this year.[iii] More recently, we have seen oil and gas producers in the US and Canada respond to high prices by cranking up production—drilling new wells and whatnot.[iv] In the Tech world, chipmakers have responded similarly to high semiconductor prices, albeit with longer lead times delaying the supply increase.[v] We have observed that a parallel cycle plays out on the demand side, as high prices prompt users to find substitutions or use resources more efficiently. That reduces demand. In concert, these factors help stabilise or lower prices.
We think these principles apply to wages, which are really the price of labour, and American data help illustrate the point. Starting with the supply side, the US civilian labour force participation rate (defined as the percentage of the American population either holding or actively seeking jobs in the trailing four weeks) has declined in recent years.[vi] There are a lot of reasons for this—some sociological, some economic. But as wages rise, job-seeking becomes more attractive to sidelined workers who either retired or stopped seeking work for other reasons, pulling them back into the labour force. (Exhibit 1) That increases the supply of workers, which eventually stabilises the price of labour. It isn’t instantaneous, and it isn’t a one-to-one relationship due to myriad other variables at work. But eventually, we think higher labour supply tends to keep wage growth in check, as there isn’t as much competition for talent. Meanwhile, on the demand side, we have long observed that high wages prompt many businesses to opt for efficiency gains over increasing headcount, which adds to the forces regulating the price of labour.
Exhibit 1: Rising Wages Help Pull People Into the Labour Force
Source: FactSet, as of 2/11/2021. Year-Over-Year Change in Average Hourly Earnings of Production and Nonsupervisory Employees and Labour Force Participation Rate, January 1965 – September 2021.
Similarly, when the price of a given product or service rises, we have found that you will tend to get much more of that product or service. For instance, if the going price for a haircut jumps from £60 to £90, that is likely going to entice a lot of people to cosmetology school. Soon the supply of barbers and hairdressers jumps, leading them to compete for business with lower prices. In the realm of physical goods, we think any smart widgetmaker will dial up production as prices rise, in order to boost sales and revenues. Eventually they overshoot, creating a supply glut that pushes prices back down—evidence for this is always plentiful on clearance racks and bargain shelves. Here, too, we think prices also regulate demand. You might opt to grow your hair out instead of paying £90 for a cut every two months. If yarn gets too expensive, you might abandon knitting and take up sewing instead. All these little substitutions multiply across the economy, helping stabilise prices. In short, companies can only raise prices if the market will bear it. Often, we see plenty to suggest it won’t.
Many commentators we follow often say the 1970s’ inflation was a wage-price spiral, but we would humbly disagree. In our view, that decade was a one-two punch of the oil shock and sweeping wage and price controls in much of the West. If you cap wages and prices and then abandon price controls, it stands to reason they will both rise, potentially by much more than they otherwise would have since price signals weren’t allowed to regulate supply. Even before you abandon price controls, if a company knows the maximum price of good or service is tightly regulated amidst an inflationary environment, that maximum often becomes the norm. The chief price controls in place now in major developed nations are the UK’s caps on the default electricity tariff (and a few other nations’ less-extreme versions of similar restrictions). So that decade just isn’t analogous to now, in our view.
We still think today’s inflation is likely to prove transitory—and price signals are a big reason why. As we have discussed in past articles, prices are up because of shortages, and those shortages will eventually ease as producers ramp up. That should put a lid on prices regardless of what wages do, in our view.
[i] Source: US Bureau of Economic Analysis, as of 2/11/2021.
[ii] Source: FactSet, as of 4/11/2021. Statement refers to Consumer Price Indexes for the US and UK. The Consumer Price Index, or CPI, is a government-produced measure of goods and services prices across the broad economy.
[iii] Source: FactSet, as of 4/11/2021. Statement based on benchmark near-term lumber spot prices.
[iv] “Canada Boosts US Natgas Exports, Drills More as Global Prices Surge,” Nia Williams and Scott DiSavino, Reuters, 24/10/2021. Accessed via Yahoo! Finance.
[v] “Chip Investment Boom Is Just Getting Started,” Robert Cryan, Reuters, 8/9/2021. Accessed via Nasdaq.
[vi] Source: US Bureau of Labor Statistics, as of 4/11/2021.
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