The U.S. economy is likely to avoid a 1970s-style wage-price spiral even as wages and inflation are rising at their highest rates in roughly 40 years.

"For a wage-price spiral to settle in, you need people to believe that inflation is going to increase indefinitely," said Gregory Daco, chief economist at consultancy EY-Parthenon. "We're not seeing that."

A wage-price spiral occurs when consumers expect higher prices to remain in place so they begin to demand higher wages to match. Businesses, in order to hire new employees and retain existing ones, have to comply, so they raise pay and pass on those higher labor costs to consumers through higher prices. Higher prices lead to higher wages, and as the spiral continues, economic conditions worsen.

Recent gains in pay and surging consumer prices have drawn comparisons to the high inflation and surging wages of the 1970s. At the time, wages and inflation accelerated to historic levels, leading the Federal Reserve to hike its federal funds rate to over 19%, an all-time high that contributed to two recessions in the early 1980s.

Still, there are signs that current conditions will not last. Consumers expect inflation will ease in the coming months, while markets expect the Federal Reserve's long-awaited rate hikes, which will raise borrowing costs and curb demand, are just around the corner.

A wage-price spiral remains a possibility, Daco said, but inflation and wage growth would need to accelerate and they currently look to be stabilizing.

Pay restraint

Average hourly wages in the U.S. jumped about 5.7% on an annual basis in January, the U.S. Bureau of Labor Statistics reported Feb. 4. The consumer price index, the market's preferred measure of inflation, grew 7% from December 2020 to December 2021, the largest 12-month gain since 1982. January's inflation figure, expected to be higher than December's, will be released on Feb. 10.

"While wage growth has risen sharply, price inflation is still higher than wage inflation, so it's hard to identify any wage-price spiral," wrote Larry Meyer, a former Fed governor and CEO of Monetary Policy Analytics, in a Jan. 28 note.

Federal Reserve Chair Jerome Powell has said the central bank is monitoring the tandem rise in inflation and wages. Still, he signaled that he was not worried about a wage-price spiral taking root.

"Wages are not a big part of the high-inflation story that we're seeing," Powell said during a Dec. 15 press conference.

Similar concerns of a spiral are also being voiced in the U.K., with Bank of England Governor Andrew Bailey calling for "restraint in pay bargaining, otherwise, it will get out of control," during a Feb. 4 BBC interview.

The risks of a U.S. spiral are increasing, but the conditions pressuring wages and prices are expected to ease as the recovery advances and supply begins to catch up with demand, said Oren Klachkin, lead U.S. economist with Oxford Economics.

"For the spiral to happen, we'd need the labor market to become even tighter and supply chain stress to increase much further than what we're seeing today," Klachkin said. "But most importantly, we'd need inflation expectations to become unanchored."

Inflation expectations

Expectations for near-term inflation are nearly 6%, while expectations for the next three years are about 4%, according to the Federal Reserve Bank of New York's latest survey of consumer expectations.

Inflation dynamics will likely cool as demand dips and consumers shift spending from goods to services, Daco with EY-Parthenon said. Federal Reserve actions that Powell has said will likely begin March, including rate hikes and a reduction in the central bank's nearly $9 trillion balance sheet, will likely reduce demand through higher borrowing costs, Daco said.

Wages, which have increased due to the dearth of unemployed Americans to fill the 10.9 million job openings, have taken off in the service sectors. Pay in the leisure and hospitality sector, for example, jumped 9.2% from April 2021 to January 2022.

"Salary growth is highest in the service sectors while price growth is highest in the goods sector — the exact opposite of what a wage-price spiral would predict," economics writer Joseph Politano said in a Jan. 12 Substack post.

Under this argument, workers in the goods sector would see relatively higher increases in pay since goods prices are rising faster than the costs of services.

Ultimately, the likelihood of a spiral may be minimal as prices inch higher and consumer behavior shifts.

"It's important to keep in mind that there's a limit to how much consumers can take in terms of price increases — and businesses are mindful of that," said Klachkin.