Pay Rises Are Smaller, Unemployment Is Lower, And Something’s Got To Give.

The Federal Reserve (the Fed) has made it crystal clear that its war against inflation won’t be over (and, therefore, it won’t stop deploying interest rate hikes) until wage growth is under control. See, those bigger paychecks just contribute to inflation. Without them, most consumers get squeezed by price rises and interest rate rises. But when pay gains match or exceed the rate of inflation, people feel confident enough to speed up their buying plans ahead of future price increases, potentially setting off a dangerous spiral of demand-driven price rises.

And the Fed’s unease about wages and inflation isn’t unfounded. Last week, data showed the US economy keeps adding jobs at a faster-than-expected pace. What’s more, the rate of unemployment dropped to just 3.5%, matching a 50-year low – in theory, that means job candidates could continue to demand even sweeter paychecks.

But in fact, the data showed that wage gains are slowing down, with December’s average hourly wage 4.6% higher than a year ago. That’s down from a 5.6% growth peak back in March, and, crucially, is still lower than the current rate of general inflation – meaning most peoples’ real incomes (that’s after adjusting for inflation) are still falling. And 4.6% wage growth isn’t exactly excessive. Many of us hope for annual pay raises in that neighborhood regardless of what inflation’s doing.

But with unemployment and wage growth falling, it’s clear that something’s got to give. If the labor market stays tight, the wage trend may reverse, and push pay up at a faster pace again. That’d be welcomed by workers but would be a headache for the Fed. Instead, what the Fed hopes to see is a slackening off of the labor market, with unemployment ticking higher and job openings falling faster. Leading economic indicators are pointing to a US economic slowdown this year, so a weaker labor market looks to be the more likely outcome at this point.

But wages are just one driver for inflation, and investors will see the whole picture on Thursday, when the consumer price index for December is released. It’s a biggie because it’s the last inflation report before the Fed’s next rate-setting meeting at the end of the month. Forecasters say December’s prices likely climbed 0.5%, compared to the month before, but anything meaningfully either side of this will likely get stocks moving one way or another.