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Are Signs of Labor Market Normalization Reflected in Wage Growth?

Regional Matters
July 28, 2023

There have been two salient features of the U.S. economy in the past two years: a tight labor market and high inflation. In the Richmond Fed business surveys, the tight labor market has manifested in a high employment index combined with a low availability of skills index; high inflation has corresponded with extreme elevation in our survey's measures of growth in prices paid and prices received. Recently, all of these survey measures have either reached or made notable progress toward reaching more historically normal levels. It is hard to imagine, however, a rebalanced labor market or reaching a 2 percent inflation target without aggregate wage growth returning to pre-COVID-19 norms.

How Do the Richmond Fed Business Surveys Measure Wage Growth?

As a part of our Fifth District surveys of manufacturing and service sector activity, we ask employers if average wages for their workers increased in the past month. The reported diffusion index represents the share who said that wages increased minus the share who said that wages decreased over that period. Both the manufacturing and service sector wage indexes reached record highs in the summer of 2021, and since then have returned to more normal pre-pandemic territory. In other words, the share of firms that report increasing wages seems to be normalizing. This is consistent with other diffusion indexes, such as those reported by the Federal Reserve Banks of Dallas, New York, and Kansas City and the National Federation of Independent Businesses.

However, the diffusion index measures the extensive margin, or the number of firms who report increasing wages, on net. Average wage growth can tell a different story if individual firms are increasing wages at a faster pace than in the past. And, in fact, this is represented in the survey data. The average percentage change that Fifth District survey participants experienced in the past year peaked in 2022, and it is still well above its pre-pandemic normal. There are a few reasons why we might see the wage diffusion indexes return to pre-pandemic levels before the percentage change variables. First, the diffusion indexes measure change in the past month, and percentage change variable measures change in the past year. Second, firms in our surveys, and contacts through other outreach efforts, have been reporting wage increases above their pre-pandemic norm.

What Do Firms Expect?

Looking forward, although firms' expectations for increasing wages has normalized (relative to before the pandemic), the percentage change expected by firms remains elevated. Pre-pandemic expected wage growth, on average, was around 3 percent (or a little below); currently, the average expectation for the next 12 months is still closer to 3.5 or 4 percent. Although the expected growth is different between manufacturing and services, both sector averages are still above their pre-pandemic norms.

The Larger Context

By most measures, wage growth is starting to come back into more normal territory. Measures such as average hourly earnings and the Atlanta Fed Wage Growth Tracker indicate that wage growth is decelerating. However, these measures and the Richmond Fed survey measures of wage change suggest that it might be some time before we see wage growth return to pre-pandemic levels.

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