In search of real — not nominal — wage gains

On Friday, the government announced average hourly wage growth for October, which came in at an annual rate of 2.8 percent.

The case was similar in September, and the media reported that Fed officials may react by tightening monetary policy. Not surprisingly, this puzzles lots of people: Shouldn’t we welcome higher wages, especially after decades of sub-par wage growth? 

The short answer is that we should welcome higher “real” wages, but the Fed does have reason to be concerned about higher “nominal” wages. Wading further into the details, while tricky, can provide some much-need clarity for decision-makers.

If you receive a 5-percent pay raise during a year when inflation is running at 3 percent, then economists would subtract the effects of inflation and say your real wage rose by only 2 percent. Most people understand this distinction at a basic level. But many people have difficulty seeing how it relates to more complex real-world issues such as monetary policy.

The Fed generally prefers to avoid huge swings in nominal wage inflation because this can destabilize the economy. A big surge in nominal wages often goes hand-in-hand with an overheating economy and higher inflation, while a sharp drop in wage growth often occurs during recessions. When the labor market is stable, wage growth generally runs at roughly 3 percent a year.

So while it’s always tempting to equate higher wages with higher living standards, we should be thinking specifically in terms of real wages.

If the Fed were to try to boost nominal wages through an easy monetary policy (i.e., putting more money in circulation), it would merely lead to higher inflation, leaving real living standards no higher than before.

There are numerous examples in Latin America and elsewhere of this approach leading to rapid wage growth, which was then eroded by high inflation. 

How do we narrow the focus to real wage growth?

To explain real wages, economists have traditionally focused solely on productivity — the average output per worker. More recently, there’s been some pushback to that simple perspective, most famously in a chart showing that real GDP per employee has increased much faster than real median wages since the early 1970s.

Some have used this to argue that average workers have not been earning their fair share, as their wages have risen more slowly than their output.

The relatively slow growth of real wages in America seems due to four factors. Three — difficulties in accurately measuring inflation, ignoring the sharp rise in fringe benefits for workers and a small increase in the share of national income going to capital (mostly due to rising real estate values in many areas) — reflect measurement issues that make the GDP/median wage comparison a bit misleading.

Importantly, none of these three factors suggest that average people are not gaining their fair share of economic growth. 

The fourth factor affecting lackluster real wage growth — wage inequality — is of greater concern. Because the wages earned by upper-income individuals have soared dramatically higher in recent decades, average wages have risen faster than median wages.

Think of nine workers who each get a 2-percent raise and a CEO who gets a 40-percent raise. In that case, the median wage rises by only 2 percent. Thanks to the CEO, the average wage rises by a much larger amount.

This is one reason why median wages have lagged behind GDP growth — more of the pie is going to workers at the top, in places such as Wall Street, Silicon Valley and Hollywood.

Public policy may play an important role in addressing this issue, either by improving labor markets so that regular workers earn more, or by supplementing their market incomes with various types of government support, such as the Earned Income Tax Credit or a basic income program. 

It is not, however, a problem that can be fixed through monetary policy. It’s true that printing lots of money can lead to higher nominal wages. However, as workers in places like Mexico and Argentina have discovered, if productivity is stagnant, then large nominal pay raises do not translate into higher real wages.

The recent 2.8 percent average hourly wage growth doesn’t pose a large threat, but the Fed has good reasons to be wary of a steep upsurge in nominal wage growth.

Scott Sumner is an emeritus professor of economics at Bentley University and director of the Program on Monetary Policy at the Mercatus Center at George Mason University.