This Friday’s data from the Bureau of Labor Statistics (BLS) could be enormously consequential for what the Federal Reserve does over the next few months. If, as we think, Friday’s data continue to show decelerating wage growth, then the Fed really doesn’t need any more interest rate increases to contain inflation. But if the Fed ignores this and tightens anyhow, the magnificent achievement of a rapid recovery from the worst economic shock of the century could be thrown away, snatching defeat from the jaws of victory. 

In March and April of 2020 as COVID-19 first spread across the United States, 22 million jobs were lost. Aided by the CARES Act passed in April 2020, the first 12 million jobs came back pretty easily over the following six months—businesses that had closed their doors but not gone bankrupt during the months of lockdown simply re-opened. But, job growth slowed in every month between August 2020 and December 2020—and in that last month employment contracted. Progress had not just stalled but gone backwards. At a similar point in the recovery from the Great Recession of 2008–2009, fiscal policymakers perversely shifted toward austerity and the result was that it took a full 10 years to regain pre-recession labor market health.

This time, however, additional fiscal support was passed in December 2020 and with the American Rescue Plan in March 2021. And since December 2020, the pace of job growth has been spectacular, with 9.2 million jobs added in 17 months—about 540,000 jobs every single month. Fiscal policy led the way on this, but the Federal Reserve has played a strong supporting role in boosting growth over this time as well. Today, unemployment is fully recovered to pre-pandemic levels and labor force participation nearly so. This is a huge policy accomplishment. 

But this jobs boom has been accompanied by too-high inflation. The most pressing current question is should the Fed continue the much-faster pace of interest rate increases they began with the June Federal Open Market Committee (FOMC) meetings? At this meeting they raised rates by 0.75% and signaled not only that more large hikes were coming, but that even the specter of overshooting and causing a recession wouldn’t dissuade them. This sharp hawkish turn didn’t come out of the blue—the Fed has been under extreme pressure from many voices to “stop being behind the curve on inflation” and to ratchet up rates quickly. These voices have essentially been trying to give the Fed permission to cause a recession, which is often cast as “needed” to bring inflation in check. 

What’s all this got to do with this week’s jobs report? Everything. Regardless of where you stand on the sources of the past year’s inflation, everybody agrees that it is the pace of wage growth that will dictate how hard the Fed will have to hit the economy’s brake to pull down inflation over the next 6-12 months. The entire case for raising rates is to slow economy-wide spending and engineer higher unemployment so that growth in labor incomes can be reined in, which will dampen both potential cost-drivers of inflation (wages) and reduce household demand for goods and services. 

What’s a specific rate of wage growth that is consistent with the Fed’s long-run inflation target and would signal the Fed could stand pat on rate increases? About 3.5–4.5%. Productivity growth (how much extra output is produced in an average hour of work in the economy) allows wages to grow about 1.5% each year while putting zero upward pressure on prices. But the Fed’s target isn’t zero inflation, it’s 2%. Add this 2% allowable inflation to the 1.5% productivity growth, and you have wages that can grow by 3.5% without adding to inflation or cutting into profits (all wage growth can be financed by 2% price increases plus 1.5% productivity growth). Add in the fact that profits are historically high now and probably should be pared back for a few years with faster wage growth, and you can easily see wage growth of 4.5% consistent with the Fed’s overall inflation target and a gradual normalization of the split of income between wages and profits. 

So, on Friday, look for how much wage growth is exceeding this 4.5% for evidence on whether we need the Fed to continue raising rates. The most popular way this wage growth is reported is year over year—comparing June 2022 wages with their levels in June 2021. But this is too backwards-looking for debates about the coming year. For example, if wages grew rapidly from June 2021 to December 2021 but have slowed a lot since then, it’s the more recent months that are more relevant for Fed decision-making.

In the last few months, it turns out that wage growth does seem to be decelerating significantly over more recent periods. Between May 2021 and May 2022, wages rose by 5.5%. But compare wages in March–May 2022 with the previous three months and this growth (expressed at an annualized rate for apples-to-apples comparisons) is just 4.3%. And for the past two months, annualized growth has been just 3.8%. 

We’ll be looking hard at this wage data on Friday. If it looks like the numbers reported above, the implications are startling: there really is no need for any further tightening from the Fed. And if they go too far too fast, the shining achievement of a rapid recovery from a horrendous economic shock could be squandered.