Putting the brakes on runaway wage growth could help avoid a recession in 2023, but it won't be easy

Strong wage growth is normally a good thing for workers and a boon for the economy.

Now? Not so much.

Average pay increases are nearing the highest level in decades, fueling inflation, the Federal Reserve says. And that could force Fed officials to raise interest rates even more next year, which risks pushing the U.S. into a mild recession. 

Economists say moderating wage growth is shaping up as key to avoiding a downturn.

But it may not be so simple.

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What is the average wage increase in 2022?

Average annual wage gains dipped to 5.2% in the third quarter from 5.7% early this year, according to the Labor Department’s Employment Cost Index. But that’s still well above the average of 3.3% before the pandemic and about 2% in the decade before the health crisis.

Robust pay increases are usually a good thing.  Since the COVID crisis, though, they haven’t nearly kept pace with inflation, meaning consumers are losing purchasing power.

But the spike in wage growth is contributing to inflation because employers with high labor costs typically raise prices to maintain profits.

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Meanwhile, the Federal Reserve has sharply raised interest rates to lower annual inflation that hit 9.1% in June before coming down to a still elevated 7.1% in December.

The Fed has hiked its key rate more than 4 percentage points in 2022, the most since the early 1980s, and is forecasting another three-quarters of a point in hikes next year to about 5.1%. That’s a level that many economists say will tip the nation into recession.

Fed Chair Jerome Powell has said the Fed will continue to hike rates until wage growth is contained.

Why are wages rising so quickly?

Inflation, especially in service industries like restaurants and health care, has stayed high as consumers shift their purchases to activities such as dining out and traveling now that the pandemic has eased. That has stoked demand for workers in those sectors and pushed up wages. Powell said price increases in those industries make up more than half of a key underlying inflation measure and they’re mostly driven by pay increases.

Labor shortages in those sectors persist because millions of Americans quit during the health crisis because of COVID or early retirement. Many aren’t expected to return. So employers must raise pay to draw from a smaller pool of job candidates or lure back those who left.

“Wages are running ... well above what would be consistent with 2% inflation (the Fed’s target),” Powell said at a news conference this month. “We have a ways to go there.”

He added, “The labor market continues to be out of balance, with demand substantially exceeding the supply of available workers.”

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What actually happens when the Fed raises interest rates?

Traditionally, the Fed raises interest rates to increase borrowing costs, weaken the economy and make it more expensive for companies to hire and invest. Increases in the unemployment rate typically lead to lower pay increases, and vice versa.

But that relationship between unemployment and wage growth – known as the Philips Curve – has frayed in recent decades, says Jonathan Millar, senior U.S. economist at Barclays.

In the decade after the Great Recession, unemployment declined steeply while wages increased modestly. That’s largely because Americans came to expect weak inflation for various reasons and didn’t demand big raises.

As a result, Millar says, roughly each percentage point increase in the unemployment rate triggers just a quarter point drop in wage growth. So, he says, it could take as much as an 8 percentage point rise in unemployment to shave pay gains by 2 percentage points to 3% to 3.5%. Such a scenario would mean a severe recession.

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Another factor that could keep wage growth elevated, Millar says, is that job openings have fallen from a record high 11.5 million a year ago to 10.3 million in October but that’s still well above the pre-COVID level of 7 million.

Even though job growth is expected to slow as the economy loses steam next year, employers may still have to offer healthy raises to attract workers because there are fewer of them, Millar says.

Is US inflation going down?

Mark Zandi, chief economist of Moody's Analytics, is more sanguine. He doesn’t believe wage growth was propelled higher during the pandemic by worker shortages but rather by high inflation expectations.

Record gasoline prices, supply chain troubles and Russia’s war in Ukraine drove consumer prices higher, prompting workers to demand bigger raises.

Now, however, pump prices have come down sharply and supply snags have improved, reducing consumer inflation expectations for the next 12 months, according to recent surveys.

“That should bring wage growth down,” Zandi said.

He expects yearly pay increases to fall to 4% by the end of 2023 and 3.5% by mid- 2024, coaxing the Fed to throttle back its rate hikes as the trend becomes clear early next year.

And that, he says, should help the economy dodge a recession.