Employment Costs And Inflation

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Based on the Consumer Price Index, the cost of the basket of goods that (supposedly) we typically buy has risen by about 20% since 2020. To offset this “inflation tax,” compensation must rise by at least as much. The government reports that real compensation has risen by -2%, meaning prices are rising faster than our incomes. And for consumers earning incomes in the bottom half of the income distribution, the real pain is much larger. It’s bad paying higher prices for groceries, but even worse if you can’t afford them at all.

Small business owners have been raising compensation quite aggressively, not because they are nice people (and they are!) but because competition forces them to if they want to retain and/or hire new workers (Chart 1). For most small firms, labor costs are among the largest if not the largest cost item in the income statement. Overall, compensation reductions are rare, with 3% or less reporting cuts in any given quarter. The 2008-2009 recession was the exception with as many as 11% reporting compensation cuts. Most recently, 1% or less reported cuts.

Increases in compensation recently reached record high levels, with up to 51% of the firms reporting increases in 2022 and 39% still reporting increases. With increases in labor costs widespread, the number of firms raising selling prices to finance the cost remains historically high as well, blunting the progress on inflation reduction.

The beginning of recessions clearly triggers a reduction in compensation raising activity, most apparent in the 2008-2009 recession and repeated in the Covid shutdown (Chart 2). The gap between plans to raise compensation and actual increases rises as the economy expands, suggesting that later in the cycle raises are not planned but are a response to market pressures. The frequency of wage increases has diminished, but remains at historically high levels, keeping pressure on labor costs (and selling prices that pass those costs on to customers).

The percent of firms raising compensation has declined substantially (9 percentage points since December 2023) but remains at elevated levels compared to pre-2020. This means that firms are still under considerable pressure to raise prices, frustrating the Federal Reserve’s efforts to lower inflation. Absent a significant decline in the economy, prospects of getting back to 2% inflation any time soon are not good. Labor cost pressures will be slow to dissipate, so inflation stays “sticky.”

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