Here’s how the worker shortage is contributing to sky-high inflation

As the labor crunch drags on, it’s forcing companies to bump up employee pay. That, in turn, can affect inflation. 

Despite the unemployment rate tumbling in recent months, the U.S. is still down about 4 million workers compared with pre-pandemic levels. Because the labor force is also smaller than it was before the pandemic, the demand for labor is strong as the economy continues to recover, which has exacerbated the shortage, PNC’s Gus Faucher recently told Fortune. Currently there are about 11 million jobs open as of October, and the number of workers changing jobs is still at record levels. 

This pressure cooker situation means that employers are on edge—and ready to bargain in order to retain and attract workers. In fact, U.S. workers’ hourly pay has increased by 4.8% over the past year, according to the Bureau of Labor Statistics. Private employees earned an average of $31.03 per hour in November, compared to $28.51 in February 2020.

That wage growth has been starting to feed into the rising prices of goods and services, which rose 6.8% over the last 12 months, the largest rate increase in nearly four decades.

“Rapid increases in labor costs are also contributing to inflation,” says Bill Adams, PNC’s senior economist. That’s because labor costs can help drive up the cost of goods and services—and can also boost spending if consumers feel more flush in the pocket.

When labor costs increase, that can boost raw material and product prices throughout the supply chain. If meatpacking plants, for example, need to increase worker pay, then they typically raise prices to cover the cost. But now restaurants are paying more for meat, and that means restaurants may need to bump up their menu prices. Already, the prices that companies paid for supplies in November were up 9.6% over the last year’s costs, according to the latest producer price index published Tuesday. While that jump reflects a number of factors, including supply-chain concerns, labor also plays a part.

This has a broad effect. About 78% of small-business owners say they have been impacted by inflation, and 63% already bumped up the prices of their products or services within the past year to compete.

And those prices, when increased to cover labor costs, are not likely to immediately tumble. Labor is a “very sticky” cost factor, and that means once companies award raises, it’s difficult to bring the cost of a good or service back down. “It’s really hard to tell somebody, ‘Hey, I’m going to bump your paycheck up to $18 an hour,’ and then when things kind of settle down, you’re like, ‘I’m gonna kick you back to $15,’” said Michael Swanson, chief agricultural economist at Wells Fargo. “Higher wages are something that once it gets built in, it’s kind of permanent,” Swanson adds.

Higher wages also feed consumer demand, since many Americans have more to spend. For example, low-wage workers spent an additional $2,800 in the year following a $1 minimum wage pay increase, according to research from the Federal Reserve of Chicago.

The U.S. has experienced a huge increase in consumer spending, writes Jason Furman, an economist and professor at Harvard University’s John F. Kennedy School of Government. And while spending on physical goods is expected to decline, Furman says it has stayed higher than many people expected.

“I would have thought everyone had enough toys, musical instruments, sports equipment, etc., by now,” Furman said. But he added that spending on services such as health care, restaurant visits, and travel is likely to rise, which will probably mean that companies need to hire or pay more—again, driving up the costs. And the cost of services is based far more on labor costs than physical goods.

The biggest uncertainty around inflation and the labor market is how the pandemic will evolve. If health fears continue to make Americans leery about taking jobs with a lot of interaction with the public, the labor market will keep tightening, and rapid wage growth will continue to fuel high inflation, Adams says. That could especially affect the rate at which Americans over the age of 55 are willing to reenter the workforce. Many of these workers retired early or exited the workforce during the pandemic and have yet to return.

“The winter surge of the pandemic is bad news for the prospects for labor force participation and creates upside risks for the inflation outlook,” Adams adds.

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