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Something strange is happening in the economy right now.

The unemployment rate is high, and financial experts keep talking about the sluggish job market recovery. At the same time, “help wanted” signs are popping up all over your city, and your local pizza place had to close early because it didn’t have enough servers.

The summer transition into post-COVID society has started, but the job market is still thawing out. Case in point: We’re in the middle of a historic labor shortage. The natural next step could be higher wages.

Graph titled A Historic Shortage of Workers tracks the percentage of managers reporting job openings are hard to fill. Between 2006 and 2009, the percentage falls from about 25% to nearly 5% before rising to nearly 40% in early 2020. In spring of 2020, it drops down to 23% before rising back up to 44% in at the start of April 2021.

Higher pay can be a good thing, especially when it’s concentrated on those who need it the most. But wage increases could present some interesting challenges in this environment.

What’s going on?

First, let’s untangle what’s going on in the job market. Companies are desperate to hire, and many people are looking for jobs. So why isn’t the labor market on fire?

It’s complicated. COVID isn’t over yet, so some job seekers are struggling to find safe working spaces or work out logistics around family care. Some may feel empowered to search thoroughly for a job that syncs up with their post-COVID lifestyles. Others may feel buffered by stimulus checks and thus, are taking their time to seek out new employment.

Plus, there’s a lot of disparity among industries. Leisure and hospitality businesses are hiring at a rapid rate, yet most still can’t keep up with demand. Manufacturing firms have had a tough time gauging head count because of supply chain issues (like the chip shortage) and material prices. Trade and transportation businesses have had trouble finding skilled labor.

Put it all together and there’s an outsized demand bubble in the labor market, which could balance out once supply of workers and demand from companies normalize. But for now, companies are turning to pay bumps and bonuses to attract applicants. Businesses such as Wal-Mart and Bank of America have raised their minimum wages this year.

Wages and Small Businesses

The ironic twist to this economic story is that it took a pandemic to stimulate some serious pay increases. Economists have watched for significant wage growth over the last decade, but it’s barely materialized amid longer-term trends like labor outsourcing, globalization and better benefits instead of salaries.

Now it seems like the tables have turned. Employers’ wage and salary costs grew the most in 15 years last quarter, mainly driven by pay raises in service industries. And there’s evidence that low-wage workers are getting the biggest pay bumps these days.

Graph titled A Historic Shortage of Workers tracks the 12-month average wage growth for workers by pay quartile from 2011 through spring 2021. The lowest-paid group starts at 1.7% average wage growth in 2011 and dips down to 1.2% in 2012 before rising to 4.7% in early 2020. As of spring 2021, it’s at 4.1%. The highest-paid group starts at 2.2% average wage growth in 2011 and dips down to 2.0% in 2014 before slowly rising to where it is as of spring 2021, at 3.0%.

It’s a positive trend for your wallet, but it could have some pros and cons for economic recovery.

For consumers, higher wages can lead to more spending. But for small businesses, higher wages could mean crippling expenses. On average, wages and salaries account for about 70% of business costs, so a small raise across the board could noticeably weigh on profit margins. For example, Chipotle management said in April that a 10% increase in wages could amount to a 2 to 3% rise in menu prices.

Big box stores like Wal-Mart and Target can absorb higher wage costs more easily than that coffee shop down the street. But when the big names raise wages, it forces smaller companies to follow suit to remain competitive.

Wages and Inflation

When businesses face rising costs, they must recoup that lost profit somewhere. Many end up having to raise their prices for goods, which in turn, boosts inflation. Signs of higher inflation have startled stocks, with investors worried that the Federal Reserve could be slower in responding to this risk.

Wages can be a big catalyst for inflation, too. Rapidly rising pay can suffocate businesses and lead to a feedback loop in which price increases get out of control. In fact, wage growth has spiked before four of the last five recessions (which coincided with market downturns). If wages rise too quickly, the Fed may feel the need to adjust monitory policy or risk the economy overheating.

The Bottom Line

Pay raises are only good for your wallet if prices aren’t rising quicker than your income. That’s why wage growth can have serious implications if left unchecked.

But context matters here. The economy is in a weird place, and there’s hope that inflationary pressures and hiring burdens will ease later this year. Tech and infrastructure improvements could also boost productivity, which could theoretically ease wages’ feedback loop on inflation. After all, if the workforce is producing more while getting paid more, companies may be able to rely on higher output instead of price increases to make up for higher wage costs.

The Fed may also choose to watch wages for a little bit longer before jumping into action. Much of the wage growth is happening in lower-paid jobs, and that could help close the inequality gap.
But the historic reality is that price increases are less likely to go down in many sectors of the economy, which is why persistent inflation is a concern.

So what does this mean for your portfolio? That’s also a mixed bag. Expansive monetary and fiscal policy have helped the stock market and economic growth, but persistent inflation could shock the markets and eat into returns.

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Speech bubble icon next to text "Expert Take" Headshot of Lule Demmissie

During her tenure as president of Ally Invest, Lule led Ally Invest Securities, Ally Invest Advisors and API business lines. She also authored several articles about the investing industry and investor behaviors. Lule has a passion for agile product development and an appreciation of design thinking in shaping user-centric experiences. An advocate for financial and retirement solutions that rely on a mix of digital and human guidance, Lule believes in empowering individuals, especially women and minorities, to independently drive their own financial futures.