Why those pay hikes are not going very far

As a restaurant manager at Zeppe's Pizzeria, Kym Costello says she's earning good money selling pizzas, subs, and some of the best French fries on the east side of Cleveland.

As a college student who drives 35 miles to class each day, she's also spending a lot - and she reckons her income is not keeping pace with the rising costs of living.

It's a common quandary in today's economy.

On average, American paychecks are rising, as employers offer higher salaries to attract and retain staff. At the same time, inflation has been heating up, burning a bigger hole in consumers' pockets.

The result is a dynamic that's challenging for workers and potentially risky for the economy.

Some analysts say now is the time for workers to enjoy an overdue improvement in their living standards. But others fear a wage-price spiral, in which pay raises ripple into the costs of goods and services, making no one better off.

"Wages are accelerating. I think that's a good thing," says Ken Mayland, president of ClearView Economics in Pepper Pike, Ohio. "But what the [Federal Reserve] will worry about is that these wage increases will just get caught up in more price increases."

That hasn't happened yet. But once a spiral starts, it can be hard to stop, experts say. Concern has risen in recent weeks. Two gauges of inflation have edged up beyond the Federal Reserve's comfort zone - with higher than 2 percent annual growth in "core" prices, which exclude food and energy.

Meanwhile, wages seem to be picking up, although a report Thursday suggested some softening of the trend. The Department of Labor said hourly compensation - which includes benefits as well as wages - rose at a 5.3 percent pace in the first three months of the year, but fell at a 0.9 percent annual pace in the final quarter of 2005.

The Labor Department's April jobs report, released a month ago, showed the sharpest rise in average hourly earnings during the current economic expansion: a 3.8 percent jump from the same month a year earlier.

Fed policymakers will be watching the May jobs report, due out Friday, for further signals on whether they need to boost short-term interest rates for the 17th time when they meet June 28 and 29. A weaker-than-expected number on job creation, for example, could temper worries that a tight labor market is fueling inflation.

"The Fed has a lot of credibility as an inflation fighter now," says Dr. Mayland. "But if it does anything to reduce that credibility, then the economy would pay the price of that for a long time."

Long-term interest rates, for example, could rise as investors demand a premium to cover expectations of higher future inflation.

Still, it isn't necessarily inflationary when wages rise faster than prices. Rising "real" (inflation-adjusted) wages are the norm in a healthy economy.

Employers typically cover the cost of pay raises by improving productivity. A reduction in corporate profits, now at record levels, is another way to pay for wage hikes. It's when pay raises lead to price hikes, and then to expectations of further gains in wages and prices, that a spiral gets going. Some current straws in the wind suggest that the risk is real enough:

• An April survey of small businesses found that more are raising prices - and about the same number say they are hiking wages.

• Companies are working harder to fill positions. With the unemployment rate down to 4.7 percent nationwide, a survey of 100 human-resource executives in April found that one-fourth of them reported a "severe" shortage of workers, according to Challenger, Gray & Christmas, an outplacement firm based in Chicago.

• Expectations of inflation have risen, according to consumer surveys and signals embedded in bond prices on Wall Street. This is important because such expectation can, by itself, help fuel inflation.

Still, not all signs point toward higher inflation.

By some measures, the labor market does not appear to be overly tight. The number of new jobs added each month hasn't been far in excess of the number of new workers entering the labor force, for example. A nationwide index of help-wanted ads has fallen in all nine regions tracked by the Conference Board in New York.

Meanwhile, consumers remain very sensitive to prices, as interest-rate hikes and flatter home prices dampen their spending power.

"Everything is in the hand of the consumer," says Rajeev Dhawan, director of the economic forecasting center at Georgia State University's J. Mack Robinson College of Business in Atlanta.

Consumer spending is much needed here in Ohio, where the pace of job creation is among the slowest in the nation. Ohio has just 0.5 percent more jobs now than it did a year ago, compared with job growth of 1.5 percent nationwide.

But at Zeppe's Pizzeria, with a "drivers wanted" sign in the window, business is brisk enough to support some raises.

"My pay here has gone up a lot since I started," says Ms. Costello, who is majoring in chemistry at Lake Erie College in Painesville, Ohio.

If the economy runs smoothly and the Fed does its job just right, she and other workers stand to benefit from more raises as the job market strengthens. Living standards should rise.

That would be a welcome reward for workers. Average hourly earnings, at $16.68 last month, are below the peak they reached in 2003, after adjusting for inflation. "It's been remarkable how little the wages have moved" as the current expansion has gained traction, says John Challenger, president of Challenger, Gray & Christmas.

Statistics for compensation, which is a broader measure of pay, appear to be brighter because benefits are included. But today's workers are reaping smaller rewards from rising productivity than they did in the past. In the 1960s and 1970s, hourly compensation grew 1.9 percent a year, adjusted for inflation.

From 1985-2004, real hourly compensation grew just 1.3 percent a year, even though per-hour output was rising at a similar pace of more than 2 percent.

One reason for the gap, economists say, is globalization, which has put downward pressure on American wages. Several billion workers are now part of a global labor market.

As labor has lost clout, investors have gained. More of the gains from productivity go to shareholders, in the form of higher profits, rather than to workers.

Now an important question is how much worker clout will bounce back.

Salaries at small businesses have risen for eight consecutive months, according to SurePayroll, a Chicago-area firm that processes paychecks nationwide. The April rise alone showed a salary gain of 0.93 percent over March.

Worker output has been improving, up to a 3.7 percent annual pace, according to the first-quarter number released by the Labor Department Thursday. That could bode well for noninflationary wage growth, as long as there's no recession. "I'm optimistic," Mayland says.