Is the oil shock turning into wage inflation?

Headline consumer price inflation rose to 3.4 per cent in July, pushed up by hundred-dollar crude. Labour economists and Federal Reserve staff now want to know whether the Gulf energy shock is turning into something more lasting, a spiral in which wages chase prices and prices chase wages.

From the pump to the payslip

Textbook theory says a temporary energy shock cuts real wages without lifting nominal pay, because households pay for dearer fuel by spending less on everything else. That holds when workers have little bargaining power. With labour tight, immigration restricted and employment close to full, workers today can press for raises to make up the difference. High-frequency payroll data suggest they are doing so: average hourly earnings in logistics, transport and manufacturing have picked up again to an annualised 4.5 per cent.

The sectors matter. Logistics, transport and manufacturing are the industries where fuel costs bite first, and where firms facing strong demand can pass dearer energy on to their customers quickly. Workers there see both the price rise at the pump and the price rise their employer is charging, which strengthens their hand in pay talks. If the pattern spreads from these sectors into services such as health care, hospitality and retail, it becomes a general wage problem.

Wages, costs and productivity

What matters for inflation is the cost of labour per unit of output. Pay can rise faster than the inflation target by the rate of productivity growth without adding to firms' costs, because each worker is producing more. A 4.5 per cent rise in hourly earnings is inflationary only to the extent that it outpaces productivity plus the Fed's 2 per cent goal. That is why the quarterly figures on unit labour costs, published alongside the productivity data, carry more weight with the Fed than any single wage series.

Measurement adds a caution. Average hourly earnings are distorted by changes in the mix of jobs, so the figure can jump when low-paid workers lose jobs, as it did in the spring of 2020, even though nobody received a raise. The Employment Cost Index, which holds the mix of jobs constant, and the Atlanta Fed's tracker of pay growth for the same individuals over time give cleaner readings. The Fed will want to see the rise in these measures too before concluding that a spiral has begun.

Restricted immigration matters because it slows the growth of the labour force. In 2022 and 2023 a surge of new arrivals helped fill vacancies and eased the pressure on pay without requiring a rise in unemployment. With that flow reduced, employers competing for a slower-growing pool of workers must bid harder, and the same pace of hiring produces faster wage growth than it did then.

Expectations are the channel the Fed fears most. If households and firms come to believe that inflation will stay near its current rate, they build that belief into pay claims, price lists and contracts, and the belief fulfils itself. Surveys of household expectations and market measures derived from inflation-protected Treasuries give an early reading, and a rise in the longer-horizon measures would carry more weight with the committee than any single wage report.

Spirals are rarer than feared

The historical record cuts both ways. In the 1970s, union contracts with cost-of-living clauses turned each oil shock into higher pay almost automatically, and inflation became entrenched until the Volcker Fed forced it down. A study of past episodes in the IMF's World Economic Outlook of October 2022 found that sustained wage-price spirals were uncommon, and that in most cases wage growth eased again as the original price shock faded. Automatic indexation of pay is now rare in America, which removes one of the channels that made the 1970s so costly.

That is the strongest argument against alarm. Workers catching up with past price rises is different from workers bargaining for future inflation, and the first can fade once energy prices stabilise. The argument has weaker force this time because the shock comes with tariffs and a labour supply constrained by immigration policy, so the tightness that gives workers bargaining power may persist even if oil prices ease.

Companies decide how much of the rise reaches prices. Firms can absorb higher wages through lower margins, which contains inflation at the expense of profits, or pass them on, which protects margins and feeds the spiral. After several years in which corporate profit margins were high by historical standards, there is room to absorb part of the increase, but only if demand is soft enough to discipline pricing, and strong consumer spending suggests it is not.

The Fed may have to act

Once workers win higher pay to cover hundred-dollar oil and tariffs on goods in the shops, the shock gets built into companies' unit labour costs. Central bankers then have to tighten hard enough to cool demand.

The costs of that tightening would fall unevenly. Workers in energy-intensive and cyclical industries would face slower hiring and possible lay-offs first, while those in sheltered sectors would see little change. Firms able to raise prices would protect their margins, and those unable to would cut staff. The data to watch are the next two employment reports, the Employment Cost Index for the third quarter and the quarterly figures on unit labour costs. The early evidence points to oil feeding into pay. If average hourly earnings keep rising at this pace, the Fed will probably have to raise rates, and workers in the sectors now winning raises may be among the first to lose their jobs.