Your pay is still going up too fast

Central bankers are nearing the end of their battle against inflation. In advanced economies, prices are now rising by 5.4% year on year, a significant drop from the peak of 10.7% seen in October 2022. However, the final leg of their journey—bringing inflation down from 5.4% to the target of around 2%—may prove to be the toughest yet. This is primarily because labor markets are not cooperating as desired.

For a while, employers were eager to hire more workers than were available, leading to an unprecedented rise in unfilled job vacancies (see chart). Between 2022 and 2023, Google searches related to "labor shortage" reached their highest levels ever. With various options available, workers began demanding significant pay raises. Year-on-year wage growth in advanced economies nearly doubled from its pre-COVID rate, approaching 5% (see chart). This increased firms' costs, prompting them to raise prices for consumers.

To bring inflation under control, wage growth needed to slow down. Given the weak productivity growth across advanced economies, achieving a 2% inflation target likely requires nominal wage growth of 3% per year or less. Central bankers hoped that by raising interest rates, they could reduce the demand for labor, ideally curbing wage inflation without severely impacting people's livelihoods.

The initial part of this strategy has been successful. The demand for labor (i.e., filled jobs plus unfilled vacancies) is now only 0.4% higher than the supply of workers, down from 1.6%. Searches for "labor shortage" have dropped by a third, and "help wanted" signs are less common.

The lower demand for labor has surprisingly had little negative impact on employment prospects. The decline in job vacancies over the past year has accounted for the entire decrease in labor demand across advanced economies. During the same period, the number of people employed has actually increased. The unemployment rate across these economies remains below 5%, with some countries achieving record employment levels. For example, in Italy, the share of working-age individuals with jobs recently reached an all-time high, suggesting a shift from "la dolce vita" to "la laboriosa vita."

Despite the decrease in labor demand, there is limited evidence of the desired outcome: lower wage inflation. While wage growth in the United States has eased from over 5.5% year on year to around 4.5%, it likely remains too high for the Federal Reserve's 2% inflation target. Elsewhere, progress has been minimal. Wage growth across advanced economies has remained around 5% year on year in recent quarters, with British wage growth exceeding 6%. Analysts at JPMorgan Chase noted last week that "very early indications for January show negotiated pay deals slowing only modestly." Wage growth in the euro area is similarly strong.

Is high wage growth, and thus above-target inflation, now a permanent feature of the economy? There is evidence to suggest so, particularly in Europe. Spanish workers, for example, have leveraged their increased bargaining power to change their contracts, resulting in a significant rise in the share of workers whose pay is indexed to the inflation rate, from 16% in 2014-21 to 45% last year. A recent OECD study on Belgium expressed concern about "more persistent inflation due to wage indexation."