Lance Roberts | Jan 21, 2022 05:17AM ET
Wage increases are undoubtedly good for workers. However, as we will explore, wage increases are a double-edged sword that often has more negative economic consequences.
Importantly, wage increases are undoubtedly good for consumers. There is no arguing that point. After all, who doesn’t want to make more money for doing their job? However, as we discussed in “$15/Hour Cost & Consequences,” wage increases are not a “free lunch.” To wit:
“Labor costs are the highest expense to any business. It’s not just the actual wages, but also payroll taxes, benefits, paid vacation, healthcare, etc. Employees are not cheap, and that cost must be covered by the goods or services sold. Therefore, if the consumer refuses to pay more, the costs have to be offset elsewhere.
For example, after Walmart (NYSE:WMT) and Target (NYSE:TGT) announced higher minimum wages, layoffs occurred and cashiers were replaced with self-checkout counters. Restaurants added surcharges to help cover the costs of higher wages, a “tax” on consumers, and chains like McDonald’s (NYSE:MCD), and Panera Bread (NASDAQ:PNRA), replaced cashiers with apps and ordering kiosks.”
The CBO also reported similarly:
Read that last sentence again.
h2 Wage Increase – Good Until You Get Inflation/h2As noted, “the net effect of increasing wages,” if not broad-based, “reduces average real family income.” The reason is “inflation.”
The current wage increase focuses primarily on lower-tier jobs such as health care, leisure and hospitality, and restaurants. Labor turnover is exceptionally high as employees jump jobs for higher pay. As labor costs rise, so do prices, as businesses pass along higher costs to consumers.
The surge in wages is certainly notable until you factor in inflation. However, as shown below, real wages for the bottom 80% of income earners are negative.
In other words, the increases in their cost of living are outpacing their incomes. As such, they have to turn to credit to fill the gap. (Such is why we have seen a surge in credit usage in recent months as liquidity drains from the system.)
(The chart below shows the gap between real incomes plus savings and the cost of living. It currently requires $4531 annually in debt to fill the cost of living gap.)
When real wages fall short, it ultimately weighs on consumption.
Employers are in a tough spot when it comes to protecting profit margins. As noted in “Inflation Surge,” the massive spread between input and consumer prices suggests corporations cannot pass along inflation entirely. Such means there is considerable pressure on profit margins in the quarters ahead.
While input costs are on the rise, the single most significant cost to businesses, as noted above, is labor. The NFIB monthly survey shows labor costs are one of the biggest concerns of small businesses. Importantly, note that while they understand they will pay more for labor, increasing wages will mark the peak of economic growth.
However, higher costs (input prices, labor, benefits, etc.) also directly affect profits and earnings.
As the CBO study noted, employers will respond to higher labor costs.
Read that last sentence again.
What economists tend to forget about rising wages is that businesses will respond to protect profit margins. Wages and costs rise, companies lay off workers, consumption decreases, and the economy slips into recession. There is a very high correlation between rising compensation and economic growth.
Such is because earnings are a function of economic growth, which is 70% comprised of consumer spending. Therefore, as higher costs get passed onto consumers in the form of inflation, their disposable income shrinks. In turn, they spend less, which leads to economic and earnings contraction.
To explain this, let’s revisit what the CBO said about the macroeconomic effects of higher wages.
Our last chart confirms the CBO analysis.
The surge in wages resulted from the confluence of $5 trillion in liquidity, creating a massive level of artificial demand with production shut down. With that liquidity reversing, demand will fall as higher costs impact corporate profitability who, in turn, react by curtailing employment. Such will lead to an eventual recession.
As shown in the chart above, rising wage growth has also preceded recessions in the economy. This time will likely be no different.
The unintended consequences of an artificial surge in demand in a weak economic environment are not inconsequential. For investors, 2022 will likely be a year of disappointment in earnings and economic growth expectations. Those disappointments will likely become magnified by the Fed’s coming policy mistake.
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