Real Wages, Inflation, and Consumer Sentiment

Wages are increasing faster than inflation. Additionally, wage growth rates are strongest for low-wage workers. Despite real wage growth, surveys show weak consumer sentiment, particularly among low-income households. A simple but perhaps overlooked factor when thinking about this disconnect is income inequality¹.

When the US entered the first period of higher inflation in 30 years, I struggled with thinking about how higher inflation would affect different groups of people. Who are the winners and losers? I’m still parsing the data on this question, but one aspect that struck me is that a commonly-used measure for answering the question is sometimes misinterpreted. Specifically, real wage growth (the wage growth rate minus the inflation rate) is not sufficient for gauging who keeps up with inflation.

To be clear, real wage growth rates are important and useful, and higher rates of real wage growth for low-wage workers are absolutely worth applauding. But the obvious issue, as I see it, is that people compare their income to their individual spending, not to the inflation rate. To see this, let’s compare two households under two inflation scenarios. 

Household A represents the bottom fifth of US households by income, with income of $12,200 per year and spending of $28,700 per year. Household A ends the year with dis-saving or borrowing of $16,700². In contrast, household B represents the top fifth of US households, with income of $175,000 per year and spending of $121,500 per year. Household B ends the year with savings of $53,500. 

Under a scenario meant to represent a typical year, both households’ income increases by three percent, and prices increase two percent (one percent real income growth). If neither household changes their spending habits, the end-of-year financial picture for household A worsens by $200 (income increases by $370 and prices increase by $570) and the financial picture for household B improves by $2,800 (income increases by $5,200 and prices increase by $2,400). 

To point out the flaw in relying solely on real income or real wages, let’s look at a high-inflation scenario. In this scenario, income increases by nine percent for each household and prices increase eight percent. The same one percent real income growth, in the high-inflation scenario, results in an end-of-year financial picture that is $1,200 worse for the low-income household A ($1,100 increase in income and $2,300 increase in prices) and $6,000 better for the high-income household B ($15,700 increase in income and $9,700 increase in prices). 

Higher inflation supercharges the already-wide gap in financial outcomes between low- and high-income households. Positive real wages, ironically, do not keep up with inflation for low-wage households, because of extreme income inequality.  To really drive this point home, under the current three percent inflation rate, the low-income household A would need annual real income growth of 17 percent to keep up with the high-income household B receiving no real income growth.