Reducing excessive wage growth could help prevent a recession in 2023, but it won’t be simple.

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According to the Federal Reserve, average salary gains are rapidly approaching their greatest level in decades, which is boosting inflation. And that might lead Fed officials to increase interest rates even further the following year, increasing the likelihood that the United States will enter a mild recession. A downturn can be avoided, according to economists, by restricting wage rise. It might not, however, be so easy.

What is the anticipated average pay growth in 2022?

The Employment Cost Index released by the Labor Department shows that average annual wage growth fell to 5.2% in the third quarter from 5.7% at the start of the year. However, that still represents a significant increase over the average of 2.5% in the decade prior to the health crisis and 3.3% prior to the pandemic.The Federal Reserve has dramatically increased interest rates in the meantime to combat annual inflation, which peaked at 9.1% in June before declining to a still high 7.1% in December.

The Federal Reserve increased its benchmark interest rate by more than 4 percentage points in 2022, the most since the early 1980s. The Fed anticipates raising the rate by another 0.75% next year, bringing the total increase to 5.1%. Many economists predict that level will cause the country to enter a recession.According to Fed Chair Jerome Powell, rates will rise further until wage growth is restrained.

Why are wages growing at such a rapid rate?
Since consumers are shifting their spending to leisure activities like dining out and travel now that the pandemic has subsided, inflation has remained strong, especially in service sectors like restaurants and health care. Because of this, demand for labour in those industries has increased, driving up pay. According to Powell, price rises in these sectors account for more than half of a key indicator of underlying inflation and are mostly fueled by pay increases.

Because of early retirement or COVID-related layoffs, millions of Americans left such industries during the health crisis. Many aren’t anticipated to come back. Employers must therefore increase salaries to attract applicants from a limited pool or entice departing employees to return.

Powell stated this month at a news conference that “wages are running… considerably above what would be compatible with 2% inflation” (the Fed’s aim). We still have a ways to go.

“The labour market remains out of balance, with demand significantly exceeding the supply of available workers,” he continued.Another indicator of inflation declines: In November, the PCE inflation rate dropped to 5.5%. Core inflation decreased as well.

When the Fed increases interest rates, what actually happens?
The Fed has a history of raising interest rates to make borrowing more expensive, undermine the economy, and make it more expensive for businesses to invest and recruit. Typically, lesser salary increases result from rising unemployment rates, and vice versa.

According to Jonathan Millar, senior U.S. economist at Barclays, this association between unemployment and wage growth, often known as the Philips Curve, has weakened in recent years.

In the ten years following the Great Recession, unemployment significantly decreased while salaries just slightly rose. That’s primarily because Americans stopped demanding significant pay increases and instead developed a low expectation for inflation.

According to Millar, this causes wage growth to decline by around a quarter point for every percentage point increase in the unemployment rate. He claims that in order to reduce salary increases by 2 percentage points to 3% to 3.5%, unemployment would need to increase by as much as 8 percentage points. A severe recession would result from such an event.

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According to Millar, a second factor that might keep pay growth high is the fact that, despite a drop in job opportunities from a record high of 11.5 million in October of last year to 10.3 million in October, that number is still significantly higher than the pre-COVID level of 7 million.Employers might still need to pay hefty raises to recruit workers because there are fewer of them, Millar says, even though employment growth is anticipated to decrease as the economy falters next year.

Is US inflation declining?
The chief economist of Moody’s Analytics, Mark Zandi, is more upbeat. He contends that high inflation expectations during the pandemic, rather than a lack of workers, drove wage increases higher.Consumer costs increased as a result of record gasoline prices, supply chain issues, and Russia’s conflict in Ukraine, which led to higher wage demands from employees.

Recent surveys, however, indicate that consumer inflation expectations for the following 12 months have decreased as a result of the dramatic decline in pump prices and the improvement in supply bottlenecks.That ought to slow wage growth, according to Zandi.He predicts that annual salary gains would decline to 4% by the end of 2023 and 3.5% by the middle of 2024, persuading the Fed to reduce its rate rises when the trend becomes apparent early the following year. And that should help the economy avoid a recession, he claims.

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