Marc-Antoine Collard
Chief Economist – Director of macroeconomic research
Wage and price setting mechanisms play an important role in the evolution of monetary policy. Although investors are convinced inflation will soon return to targets, how the dynamics of inflation evolve will depend on different underlying assumptions, thus impacting central banks’ decisions.
This is not the 1970’s…
The commodity price surge in the wake of Russia’s invasion of Ukraine has exacerbated already elevated inflationary pressures driven by the pandemic’s supply disruptions. In that regard, the situation resembles the 1970’s supply oil shocks. Furthermore, then and now, monetary policy was highly accommodative in the run-up to these shocks.
However, in the 1970s, general wage indexation was a powerful force in the pricewage loop: when consumer prices rose by 1%, wages automatically rose by 1%, which increased firms' costs in proportion to their wage bill, pushing up prices. But in the 1980’s, most countries have decided to stop/ban indexation clauses. Furthermore, there has been a paradigm shift in monetary policy frameworks since the 1970s. At that time, central bank mandates incorporated multiple competing objectives, including for output and employment, and policymakers were inclined to attribute rising inflation to special factors, underestimating the pervasive and lasting impact of excess aggregate demand pressures. In contrast, today’s central banks have clear mandates for price stability, expressed as an explicit inflation target, and have established a credible track record of achieving their targets. As a result, inflation – in particular, core inflation – has become much less sensitive to inflation shocks.
In fact, investors are convinced inflation will return to targets. Indeed, after decades of building credibility, inflation expectations are likely to remain well anchored. Also, as central banks tighten monetary policy and pandemic-related fiscal stimulus is unwound, demand will slow. Simultaneously, as the supply disruptions caused by the war in Ukraine ease, commodity prices will stabilise, and as global production lines and logistics adjust, so will supply bottlenecks.
… but the labour market will play a key role in the inflation outlook
Yet, how the dynamics of inflation evolve will depend on different underlying assumptions, especially regarding the labour market. In that regard, the WS/PS model(1) is a good starting point. In particular, there are four factors that could determine the speed at which inflation is likely to converge toward central banks targets:
A. The extent of real wage catchup
In theory, the lower the unemployment rate, the higher nominal wage growth. However, if actual inflation turned out to exceed expected inflation, real wages (or purchasing power) will end up being lower than worker’s assumptions. In the next year, will this loss be irrelevant for wage setting, or will workers want to catch up? Obviously, which of the two paths is relevant does strongly affect the dynamics of inflation.
B. The degree of anchoring of inflation expectations
The anchoring of inflation expectations is a necessary condition for central banks to maintain price stability, as it prevents temporary shocks to inflation from feeding into the mechanisms of wage and price formation.
On the one hand, whatever happened to inflation in the past, wages could be set on the basis of a constant expected rate of inflation (i.e. the central bank’s inflation target). In that case, the credibility of the central bank is very strong. On the other hand, the more expectations are de-anchored, the more inflation last year will affect inflation this year as the credibility of the central bank is called into question.
C. The slope of the Phillips curve
The Phillips curve illustrates a negative relationship between the unemployment rate and inflation. Thus, when the unemployment rate is low, the inflation rate tends to be high since workers’ bargaining power is strong and businesses tend to hold a high pricing power.
If one assumes that the slope is relatively flat, then even very tight labour markets have a limited effect on wage inflation, all else equal. However, if the relation is nonlinear, then the effect of unemployment becomes increasingly relevant, and overheating may lead to substantial pressure on wage inflation.
D. The response of wage to prices
Are movements in wages, or more specifically movements in unit labour costs, being passed through fully to prices? Do businesses have a strong pricing power?
The jury is still out
Based on data going back a few decades, the empirical evidence suggests: no catchup in real wages, anchored expectations, and a relatively flat Phillips curve(2). In that regard, investors might well be right in expecting a rather smooth return of inflation to target. However, several elements merit closer examination.
First, the past few decades were characterized by stable inflation and no relevant labour market or goods negative supply shocks, and thus might not be a reliable guide to the future. In fact, when nominal wages rarely lag substantially behind prices – i.e. when there is no significant loss of purchasing power – then workers may not focus on catching up and may not take variations in inflation into account. Yet, when inflation is substantially higher, workers may very well start paying attention and demand a catch up for the loss in purchasing power, especially when inflation is too high for too long. And they may be able to obtain such wage increases thanks to elevated bargaining power in a very tight labour market.
Indeed, vacant jobs in many countries have been hard to fill as COVID-19 which can be explained in part by a change of workers’ job preferences. For instance, in the US, resignations have risen beyond what their historical relationship with vacancies would imply, suggesting that workers are not just seizing opportunities, but also searching for better working conditions. In addition, COVID-19 have produced sectoral and occupational mismatch that could have increased labour market tightness as workers take longer to find employment in new sectors and firms. Labour markets tightness also reflects a slow post-pandemic recovery in supply, with, in particular, fewer older workers participating in the labour force. In some countries, lower-skilled workers previously employed in contact-intensive industries have remained outside of the labour force, shrinking the pool of available job seekers(3).
Furthermore, the 1970’s showed that inflation expectations ultimately became de-anchored because of persistently elevated inflation and repeated inflationary shocks, although in an environment of higher inflation and a less credible central bank compared to today. Still, wider and faster diffusion of information could serve as a catalyst for looser inflation expectations. In that case, the interest rate path required to bring inflation back to target will be greater than those currently anticipated by financial markets. This raises the spectre of the steep increases in interest rates that brought inflation under control but also triggered a global recession in 1982.
Meanwhile, much research shows a link between unit labour cost (ULC) and price inflation, although the interaction is non-linear. Unsurprisingly, the relationship is weak at shorter horizons. It is also affected by the anchoring of inflation expectations as the credibility of the monetary policy seem to have played a larger role for price setting than cost pressures.
However, academic literature also suggest that the link depends on the inflation regime prevailing in the economy: when inflation is high, the relationship becomes stronger(4). In fact, when coming from a prolonged period of low inflation, this pass-through could be moderate, but when inflation is too high for too long, it may become more significant.
Meanwhile, ULC depends on labour costs, but also on productivity. Businesses can absorb higher labour costs via lower profits or by using automation and other methods to improve efficiency. Higher wages combined with robust productivity would in fact prevent an acceleration in ULC, and thus in inflationary pressures.
Yet, the pandemic struck the global economy after a decade that witnessed a broadbased decline in productivity growth, and that trend persists. Therefore, a tight labour market combined with disappointing productivity growth is a toxic environment for the inflation outlook. In this context, investors’ scenario of a relatively painless return of inflation rates to targets could prove highly uncertain. In that regard, history shows that in the early 1980s, Fed Chairman Paul Volcker was forced to deteriorate the US labour market to curb inflation. More generally, the tightening of monetary policies around the world contributed to the global recession of 1982, but global inflation fell to around 5% per year, on average, during the rest of the 1980s, from more than 11% during the previous decade. Short term pain, but long term gain.
Associated file
Dowload file (PDF)
