How wage inflation became the Feds regressive red line

The 2021-2023 inflation surge saw sudden and persistent increases in prices for consumer goods, housing and assets.

Wage inflation also rose, but it lagged behind other inflation measures. When wages finally accelerated, the Fed began hiking rates to cool the economy, consistent with its longstanding view of wage inflation as a precursor to spiraling inflation and the need to suppress it.

At first glance, the average weekly wage for the last two decades appears strong, often outpacing general inflation. Data from the Center for American Progress indicate that workers, especially lower-income workers, have seen real gains between the Covid-19 pandemic and late 2024.

Yet these figures can be misleading. Recessions often skew the numbers because lower-paid workers are more likely to be laid off while higher earners remain, and new hires during recoveries can temporarily boost averages through starting pay or signing bonuses.

Meanwhile, common inflation metrics like the consumer price index (CPI) for all urban consumers can often understate the cost of living for lower-income households, and most wages remain below pre-pandemic levels. In fact, real hourly wages for most workers have barely moved since the 1970s and have typically been slow to recover once they fall behind.

While the Fed has long viewed suppressing wage inflation as central to stabilizing the economy and preventing runaway inflation, this was not always its primary mission. The Federal Reserve was founded in 1913 to prevent banking panics by providing liquidity to struggling banks, with its authority expanding dramatically during the Great Depression as it took on a central role in monetary policy, bank supervision, and financial system oversight.

The 1951 Treasury-Federal Reserve Accord restored the Fed’s independence to set interest rates after the government assumed control during World War II, allowing it to experiment with new monetary approaches.

By 1958, the Phillips Curve began to be employed, suggesting a trade-off between unemployment and inflation. Economists believed that keeping interest rates low would encourage businesses to hire more workers, raising wages, which in turn would boost spending.

This approach worked until the 1970s. Thereafter, high government spending, the decline of US manufacturing, and repeated oil shocks triggered stagflation. High inflation and unemployment, combined with slow economic growth, showed that traditional interest rate policies could not control inflation and support growth.

After Congress formally adopted the Fed’s dual mandate of supporting maximum employment and price stability in 1977, the central bank asserted its independence by treating price stability as the priority. When Paul Volcker became chairman in 1979, the Fed elevated inflation control above all other objectives.

Volcker and other policymakers viewed rapid wage growth, especially when driven by expectations of future inflation, as a sign that inflation psychology had taken hold. They argued that if workers expected inflation, they would push for higher wages, and businesses would respond by raising prices to cover their costs, setting off a wage-price spiral.

The Fed responded with aggressive rate hikes to slow hiring and reduce workers’ bargaining power, aiming to keep unemployment low enough to sustain economic activity, but high enough to prevent rapid wage growth.

Judging success and other options

The Fed’s strategy became orthodox, but its success has been mixed. It certainly helped tame inflation and return the economy to growth, but real wages have stagnated for most workers since. Meanwhile, the financial sector expanded dramatically, benefiting from higher margins, speculation and rising asset prices as the Fed focused on wage inflation instead.

By the mid-to-late 1990s, however, the Fed demonstrated that wage growth and price stability could coexist. Fed Chairman Alan Greenspan allowed the economy to run hotter than some economists recommended, betting that productivity gains from technology would keep inflation in check.

Unemployment fell to historic lows, and lower-income workers in particular saw modest wage gains. In the 2000s and 2010s, inflation remained moderate, and wages remained largely stagnant.

After nearly three decades of low inflation, the inflation surge of the early 2020s was driven largely by corporate markups, supply chain shocks, and energy prices, and not wage growth. From the early 1990s through the 2010s, wages were also not a significant source of the limited inflation. Instead, asset bubbles (most notably the 2000s housing bubble), along with food and energy price shocks, were responsible for price increases.

While economic bubbles typically enrich the wealthy, long periods of low inflation also benefit them under the current system. Higher interest rates lift returns on safe assets such as Treasury bonds, which supports financial institutions and investors, and low inflation reduces pressure on large firms to raise wages.

The Fed’s emphasis on keeping prices steady helps maintain financial stability, supports government borrowing, and reinforces confidence in the dollar. Wage growth often struggles to keep pace with rising wealth at the top, but the overall arrangement remains acceptable to the Fed.

Other countries have taken different approaches to managing inflation and wages. The Bank of Japan, for example, has actively tried to boost wages since the 2010s to counter decades of stagnant incomes and low inflation, aiming to stimulate domestic spending and growth. China has focused on containing asset price bubbles to limit wealth concentration, while also promoting wage increases to support consumption.

Some financial experts suggest that the US could adopt similar or alternative strategies. Economists Scott Sumner and Christina Romer have endorsed nominal GDP targeting, which would have the Fed focus on keeping the total dollars spent in the economy on a steady path.

Unlike today’s approach, which reacts mainly to price changes or unemployment, this could help prevent sudden economic slowdowns and keep wages and jobs more stable.

Isabella M Weber and Merle Schulken, along with their coauthors, highlight “seller’s inflation” in their policy paper, where a few dominant companies push up prices in certain industries. They suggest targeted price controls in some markets to prevent excessive increases.

Economists Bill Mitchell and Warren Mosler propose a job guarantee concept called Non-Accelerating Inflationary Buffer Employment Ratio (NAIBER), where the government hires anyone willing to work at a fixed wage. This policy is meant to keep prices stable while ensuring full employment.

Other reforms, including widening inflation measures to more effectively cover corporate profits, rents and asset prices, could help prevent unchecked wealth accumulation at the top. Policymakers could also focus more on wage growth that keeps up with productivity rather than just tracking nominal pay, particularly as productivity has been surging since 2023.

Sustainable, widespread wage growth will be difficult. The US no longer benefits from the massive economic expansion and strong labor bargaining power that lifted wages for most workers in the decades after World War II.

In the modern financial and technology-driven economy, high-skill workers see significant wage gains, lower-income workers occasionally experience short-term boosts, but the middle class often struggles to keep up.

The Fed’s focus on controlling inflation has contributed to this imbalance, allowing wealthier households to gain faster, while rising asset values widen inequality. But slowing wage growth to fight inflation has gone on too long, and the 2020s inflation surge showed it wasn’t responsible for increasing prices.

Reassessing the Fed’s priorities could help ensure that rising wages for typical workers are no longer treated as a threat, but instead used to strengthen the economy and reduce growing inequality.

John P Ruehl is an Australian-American journalist living in Washington, DC, and a world affairs correspondent for the Independent Media Institute. He is a contributor to several foreign affairs publications, and his book, “Budget Superpower: How Russia Challenges the West With an Economy Smaller Than Texas”, was published in December 2022.

This article was produced by Economy for All, a project of the Independent Media Institute and is reproduced with kind permission