There is a double whammy of good news on the American economy. In its inflation update for September, the U.S. Bureau of Labor Statistics reported that consumer-price inflation is now down to 2.4% per year. Even better is the news on producer prices, which are now in deflation for the second month in a row: the Producer Price Index fell by 2.5% from September last year.
Producer price deflation reinforces the moderation of consumer price inflation. However, there are two dark clouds on the horizon, both of which could have serious negative consequences for the U.S. economy in 2025.
One of the clouds is, of course, the unending budget deficit; in the 2024 fiscal year, which ended on September 30th, the U.S. government borrowed a staggering $2.3 trillion. Although most analysts do not seem to grasp the full amount of the deficit—the number $1.8 trillion is often mentioned—this Gargantuan fiscal problem is nevertheless well-known. Therefore, at least theoretically, we can expect Congress and the new president to maybe get to work on it as soon as the November election is over.
The other cloud is much less known. As far as I can tell, I am the first to point to it. There is trouble in the labor market, where we are seeing the first warning signs of labor-cost-driven inflation.
One big problem is that unions have decided to call workers out on strike for massive pay hikes. At Boeing, the aerospace manufacturer, thousands of machinists went on strike a month ago and there is no end in sight. They started the strike after rejecting an offer for 25% wage hikes over four years (sugarcoated with improvements in their employment benefits). They appear to be ready to hold out to get what they really want: a 40% increase over three years.
This amounts to just over 13% per year. If inflation stayed where it is right now, just below 2.5%, then by the end of 2027, the Boeing machinists would have increased their real wages by one-third. This is a very large pay hike by any comparison.
Meanwhile, some 45,000 longshoremen at U.S. harbors along the eastern seaboard and the Gulf coast recently went on a brief strike. They, too, want significant pay raises over the next few years. While not as aggressive on a year-to-year basis as what the Boeing machinists demand, they are stretched out over a longer period of time. The latest offer, which is currently being discussed while the strike is on hold, would give them a guaranteed 10% increase every year through 2030.
Both these strikes follow on the heels of last year’s strikes by UAW, which organizes workers across various vehicle industries. Understandably, workers are frustrated over how the 2021-2022 inflation episode ate away at their real wages, but they fail to realize that they are themselves playing with inflation fire. Bluntly speaking: if they set the trend across the labor market, they could end up in a situation where a new wave of price hikes will eliminate all their recent wage gains.
Before we look at some numbers, it is important to remember that wage increases per se do not drive inflation. There is a widespread misunderstanding on this point among economists who specialize in the labor market. In general, developed economies experience a slow but relatively steady improvement in labor productivity. Businesses put new equipment to work which allows workers to produce more without raising production costs; workers become more efficient with a given set of resources; businesses learn to organize production in new ways that save money and improve output. These productivity and efficiency gains free up money for a number of things, including increases in labor compensation.
If we look at the period 2011-2019, when U.S. inflation averaged 1.8% per year, the average private sector weekly paycheck increased by 2.5%. Although a real pay hike of 0.7% per year is not very much, the combination of low inflation and a slow but steady growth in real wages was good for everyone in the U.S. economy.
While increasing per-employee pay by an average of 2.5% annually, U.S. employers also added more workers to their payrolls. With an almost 2% annual increase in their workforce, they saw total weekly payroll costs increase by 4.5% per year.
Since we left the 2020 pandemic and the 2021-2022 inflation episode behind us, wage increases in the U.S. labor market have stabilized again, but at a higher level than before. So far, through 2024, payroll costs in the private sector have been 5% higher over last year, again compared to 4.5% on average in 2011-2019.
The number of employees has continued to increase at about the same rate, which means that the 0.5 percentage point extra increase in payroll costs comes from rising wages.
Let us keep this in mind as we return to the wage hike demands from the Boeing machinists and the harbor longshoremen. If they get to set the norm for the entire private sector going forward, we will run into big problems in short order. If private sector payroll costs increased by 10% per year (the longshoremen’s demand; the machinists want 13%), it would add more than $1.3 trillion to the private sector’s cost of doing business.
These numbers are based on the assumptions that inflation stays at 2.5% and that the privately employed workforce continues to grow at a rate of 1.5% per year. We should also keep in mind that productivity usually improves by up to 2% annually.
Nevertheless, we are left with 5.5-6% payroll hikes that American businesses would love to pass on to their customers. If they pass this on to consumers, it would by a rough estimate add 3-3.5 percentage points to the ‘normal’ 2.5% inflation rate. In other words, we could be looking at 5.5-6% inflation.
It takes time to materialize, and probably will not strike us in full force before 2026. With that said, I would not discount the possibility that the compound effect of high wage hikes within a short period of time—from now to the spring—could bring this inflation rate to bear as early as the second half of 2025. And contrary to monetary inflation, this one could last over multiple years.
