The Big Idea

Keeping up with inflation

| April 1, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

There is no question that inflation is taking a big bite out of households’ purchasing power. A number of commentators have highlighted the fact that inflation is rising faster than the average increase in wages and leaving households behind in real terms.  A detailed look at the data suggests that households, while hit hard by price hikes, may be faring somewhat better than generally thought. More people are working slightly longer hours, leaving real income up and likely to keep rising.

Inflation benchmark

The Bureau of Economic Analysis recently released February data for the PCE deflator.  This is the Fed’s preferred gauge of inflation.  The 12-month increase for the PCE deflator through February was 6.4%, the fastest pace of price hikes in roughly 40 years. Nominal wages need to have risen by 6.4% for households to keep up with inflation.

Wage measures

The most popular measure of wages is average hourly earnings, a monthly indicator published by the Bureau of Labor Statistics.  Through February, average hourly earnings for all employees were up 5.1%.  Adjusted for the PCE deflator, this would put real wages at -1.3% for the past 12 months, suggesting that the average worker was not keeping up with inflation.

The BLS publishes a series called “Real Earnings” that deflates average hourly earnings by the CPI.  Since inflation as measured by the CPI is running considerably higher than for the PCE deflator, the BLS’s real earnings gauge is even further in negative territory.  It fell by 2.6% in February.  This figure is frequently cited in the financial and general press.

As it happens, the published Real Earnings gauge is about as unfavorable a comparison as could be devised. Alternative calculations are mostly less negative for workers. For example, a narrower but probably more reliable average hourly earnings series that only measures the pay of production and nonsupervisory workers—those who actually get paid by the hour—posted a 6.7% rise in the 12 months through February, well above the more-heralded aggregate series.  Adjusting that measure by the PCE deflator yields a modest rise in real wages over the 12 months through February of 0.3%, not a great outcome but much better than -2.6%.

Another alternative wage measure is the Atlanta Fed wage tracker, an indicator that I have highlighted in the past. This indicator is derived from a subset of the household survey data.  Unlike the average hourly earnings figures, it compares wages for the same individuals observed 12 months apart, so that it eliminates fluctuations caused by changes in the composition of the workforce.  The median rise in the Atlanta Fed wage tracker jumped to 5.8% in February.  Even so, this works out to a slight decline of 0.6% in real terms.

In sum, it looks like hourly wage rates have broadly tracked price inflation, depending on which measure we choose, perhaps averaging out to a slightly negative real change over the past 12 months.

A more complete accounting: income versus wages

Focusing on hourly wages as the primary gauge of household finances, however, misses a big part of the picture.  Doing so implicitly assumes that hours worked do not change.  As an extreme example, if my hourly wage is unchanged but my average workweek doubles, say from 20 hours to 40 hours, then my wage income has doubled.  In addition, as unemployment falls, a higher proportion of households is earning wages, so that aggregate household income may be rising even if the income of the average household is not.  In this scenario, real consumer spending could still expand, even if the typical household lost ground to inflation.

Thus, the BEA’s personal income data offer a better read than hourly wage figures on whether households are keeping up with inflation.  Once again, however, the most commonly cited data may not be the most accurate for our purposes.  The headline personal income data includes government transfer payments.  Federal payments, both rebate checks and expanded unemployment benefits, boosted personal income sharply in early 2021.  Year-over-year comparisons consequently are currently somewhat distorted.  In February, personal income was up by 6.0% year-over-year, which would work out to a slight decline after inflation.

Within the personal income report, the BEA reports a real income gauge: real disposable income.  This metric takes income, subtracts tax payments, then adjusts for inflation using the PCE deflator.  This widely cited figure posted a 1.6% drop in the 12 months through February.  Normally, this would be a quick and easy way to gauge how household finances are holding up in real terms.  However, again, the comparison is currently distorted by the elevated level of government payments a year ago.

If we limit the income calculation to wage and salary income, the picture looks much better.  Wage and salary income surged by 11.5% in the 12 months ended February.  Note that this incorporates the roughly 5% to 6% hourly wage gains plus the increase in the number of people employed—4.6% based on payroll figures—plus an extension of the length of the workweek on average, up 0.3%.  It also includes non-hourly compensation such as various types of bonus payments.

If we apply the 12-month increase in the PCE deflator to this gauge, the real gain is a healthy 5.1%.  This helps to explain how consumer spending has risen substantially over the past 12 months, rising by 6.9% in the 12 months to February.


Of course, the next 12 months will probably look considerably different than the last 12.  Hopefully, the pandemic is mostly behind us.  Employment gains may slow at some point, but inflation is broadly expected to moderate as well.  What is the outlook for household finances going forward?

I can venture a rough guess.  My projections call for average hourly earnings to rise by almost 5% again in the 12 months to February 2023, as an extremely tight labor market continues to generate sizable pay gains.  The workweek may extend by another tenth, adding 0.3%.  My payroll estimates call for a 2.8% rise in employment.  That adds up to around an 8% nominal advance for wage and salary income.

Meanwhile, I look for the PCE deflator to rise by about 4% over the 12 months through February.  Even though my inflation forecasts are higher than the private consensus and the latest FOMC projections, I worry that they are too low.  Nonetheless, my guess is that if inflation runs substantially higher than that, nominal wages will likely also accelerate, largely offsetting the price hikes.

In any case, my projections work out to around a 4% real increase in wage and salary income over the 12 months through next February, down modestly from the 5.1% rise in the 12 months ended February.  Such a slowdown would be consistent with a moderation in real consumer spending over the next four quarters.  I expect real consumption over that timeframe to increase by around 3.25%, a substantial deceleration from the outsized gains posted in early 2021 but still well above the presumed long-run trend for the economy.  And that’s without households dipping substantially into their extra accumulated savings or their unrealized wealth gains.

In sum, while inflation is likely to be a drag on the consumer, it is unlikely to prevent households from continuing to spend at a solid clip this year.

Stephen Stanley
1 (203) 428-2556

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