American workers have been shortchanged in the recovery from the Great Recession. With more job seekers than job openings, employers have faced little pressure to raise wages. Weak demand has also limited producers’ ability to raise prices, but the burden of weak demand has fallen mainly on wages, which have shrunk as a share of employers’ costs over the course of the recovery as profits have grown.

Most forecasters, including those at the Federal Reserve and the Congressional Budget Office, expect that as the recovery continues demand for labor will strengthen and wages will start growing faster. Should that happy event occur, policymakers should turn a deaf ear to the likely cries from inflation hawks that faster wage growth signals an imminent wage-price inflation spiral.

In the August update to its budget and economic outlook, CBO projects the growth of hourly labor compensation to accelerate over the next three years from around 2 percent a year to around 3.5 percent. As the budget office states, “The growth of hourly compensation has been remarkably slow since the onset of the recession; the anticipated pickup of that growth during the 2015 to 2017 period is consistent with the expected strengthening of demand for workers.”



How can wage increases go from 2 percent per year to 3.5 percent without igniting unacceptable inflation? The answer lies in the arithmetic of prices, productivity and labor costs.

In round numbers, since the start of the recession in late 2007, hourly labor compensation (wages plus fringe benefits) has grown at about 2 percent a year on average. Productivity growth (increases in output per hour worked) offset about 1.5 percentage points of that increase. The difference, a mere 0.5 percent a year, is the growth rate of labor costs per unit of output produced.

Prices were rising three times as fast as that over this period – 1.5 percent per year – so businesses had three times the revenue per unit of output they needed to cover the increase in unit labor costs. It’s not surprising that profits grew substantially while workers got the short end of the stick. Businesses could have raised hourly compensation by 3 percent a year over this period (half paid for by higher prices, half by greater productivity) without threatening their bottom line.



CBO projects that inflation will rise gradually toward the Fed’s stated longer-term goal of 2 percent per year. That means hourly compensation can rise at 3.5 percent a year without putting any additional upward pressure on prices: Price increases would cover 2 percentage points of that increase, and greater productivity would cover the rest.

Fed policymakers understand this arithmetic and how substantial “slack” in the labor market since the onset of the Great Recession has restrained wage growth. Inflation hawks, in contrast, have misunderstood the dynamics of the economy and Fed policy from the onset and will likely do it again.

