Household Inflation Uncertainty and Wage Growth Expectations

This paper investigates how subjective household inflation uncertainty around future prices shapes employed individuals’ expectations of nominal wage growth. Utilizing detailed microdata from the Federal Reserve Bank of New York’s Survey of Consumer Expectations (SCE), we document two key empirical findings: (i) individual-level inflation uncertainty is positively associated with wage growth expectations, and (ii) this relationship is marginally higher for low-income households. To address potential endogeneity arising from wage-price dynamics, we propose a novel instrumental variable strategy that exploits variations in forecast imprecision for highly salient consumer goods (gasoline and food). Our identification leverages the cognitive heuristic that individuals use ”round numbers to represent uncertain forecasts,” generating quasi-exogenous variation in inflation uncertainty. To interpret these empirical findings, we develop a search-and-matching model of the labor market with heterogeneous worker wealth, extending the framework of Krusell et al. (2010) to incorporate wage bargaining under uncertainty. We propose wage bargaining under uncertainty, combining the alternative offer bargaining wage bargain proposed Hall and Milgrom (2008) with the solution for bargaining under uncertainty developed in White (2008). In our model, nominal wages are negotiated before the realization of inflation. Risk-averse workers, facing uncertainty about their future real purchasing power, demand higher nominal wages as compensation for bearing inflation risk. This compensating risk premium mechanism plays a pivotal role, explaining why increased inflation uncertainty leads workers to form higher nominal wage growth expectations and negotiate higher wage increases.