The Effects of Inflation on Wage Adjustments in Firm-Level Data : Grease or Sand?

This paper studies the effects of inflation on wage changes made by firms in a unique thirty-seven-year panel of occupations and employers drawn from the Federal Reserve Bank of Cleveland Community Salary Survey (CSS). Our analysis first identifies two relative prices embedded in wage changes and, second, draws inferences about the costs and benefits of inflation from the adjustments in these relative prices. Typically, firms manage employer-wide wage adjustments (controlling for occupational wage changes) separately from their interoccupational wage changes (controlling for employer wage hikes). Consistent with this observation, we identify large independent employer and occupational components of wage changes in the CSS. Although there is no a priori reason why these adjustments should be altered by inflation (when the average change is subtracted out), we find that variation in both of these terms rises as inflation grows. Guided by institutional wage-setting procedures, we view employers' mean wage hikes as subject to intra-market variations in the speed of adjustment to inflation and forecasting errors. In contrast, we argue that occupational wage movements include a higher concentration of inter-market relative price adjustments. This simple dichotomy, whose robustness we attempt to test, yields two policy-oriented results. First, higher inflation and labor productivity appear to increase the rate of occupational wage adjustments 'grease'), although these potential benefits taper off after inflation rises to about 4 percent (assuming 1.5 percent average growth of labor productivity.) Second, potentially inefficient variations in employer wage adjustments ('sand') continue to mount until inflation reaches rates of 7 to 10 percent (again assuming productivity growth of 1.5 percent)