The dreaded “wage-price” spiral is an historical artifact

TS Lombard has written a note (below) downplaying concerns of a 1970s-style “wage-price” spiral, suggesting it is an historical artifact that won’t be repeated in “the modern, globalized, high-tech economy, where workers and individual firms have much less bargaining power”.

I wholeheartedly agree. In Australia’s case, centralised wage fixing was abolished and workers have never had less bargaining power. This alone makes comparisons to the 1970s redundant.

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  • Central banks believe wages are now the main inflation threat
  • The BIS outlines the nightmare scenario for the monetary authorities
  • But we haven’t seen a genuine wage-price spiral in decades

There is currently an intense argument about who is to blame for inflation at 40-year highs. Was it greedy corporations, government stimulus, “monetary financing”, Vladimir Putin, or just a lot of bad luck? We can shed some light on this question by looking at the composition of unit prices, breaking inflation down into contributions from margins, unit labour costs (wages adjusted for productivity) and other (non-labour) costs. Chart 1 shows this decomposition for the US, where the data are readily available. Clearly, an expansion in profit margins explains a big part of the acceleration in prices over the past two years, particularly during the pandemic. Presumably this is where the “corporate greed” narrative comes from. But, of course, this is exactly what we would expect to see in an environment where demand was strong and supply chains impaired. It does not necessarily mean companies have become greedier or that our economies have become less competitive. And the expansion in margins that took place during the pandemic does not, in fact, tell us anything about the likely persistence of inflation – which is what matters right now.

Contribution to prices

Today, the biggest worry – particularly among central bankers – is that the underlying driver of inflation is shifting. Wages, which were definitely not the cause of inflation in 2021-22, are starting to accelerate, and this could produce a more persistent CPI overshoot, even as the “transitory” effects of the pandemic fade. We can this in Chart 1, where the contribution from unit labour costs has begun to increase. Cost pressures associated with COVID-19 and the war should ease, but wages would offer a more persistent inflationary impulse. The authorities call this dynamic “second-round effects” or, worse, the dreaded “wage-price spiral”. To get a sense of why central banks fear this process, I recommend the latest BIS annual report, which includes a detailed “under-the-hood” analysis of inflation. In a message that clearly resonates within officialdom, the BIS argues that the wage-price spiral is absolutely central to any persistent inflation episode. It is the mechanism that will push an economy from a “low-inflation regime” to a dangerous (selfsustaining) “high-inflation regime”. And once an economy has made this transition, it can be extremely costly for the authorities to restore the old, low-inflation environment.

So, is a wage-price spiral now inevitable? The BIS, along with most central bankers, puts a great deal of emphasis on expectations. When people get used to high inflation, workers will demand higher pay and companies will be willing to hike their prices. This is the “official” story for what went wrong in the 1970s, when central banks were not sufficiently aggressive to prevent a high inflation culture taking hold. It explains why we suddenly have Jerome Powell celebrating the legacy of Paul Volcker, the ECB reminding us of its Bundesbank heritage and the BoE’s Andrew Bailey taking every opportunity to tell the British public not to ask for a pay rise. Personally, I have never been convinced by the “expectations fairy” or the popular explanation of what took place during the 1970s. The Great Inflation was essentially a power struggle, which won’t be repeated in the 2020s…

Moderately faster wage growth does not, however, mean anything is going to “spiral” or that central banks are going to be stuck with inflation way above their targets. Indeed, on the basis of what has happened over the past 20 years (Chart 2), stronger wage growth is more likely to be accompanied by a squeeze on margins than continued rapid price hikes. When people talk about the inevitably of a wage-price spiral, they assume margins are always constant and companies will pass on any cost pressures. This was true in the 1970s, but it does not describe the modern, globalized, high-tech economy, where workers and individual firms have much less bargaining power than was the situation 50 years ago. Companies were able to expand their margins during the pandemic, but it is stretch to believe this is indicative of a “new pricing culture”.

Margins versus wage growth

We should also remember that there is a distributional and political aspect to central banks’ angst about a wage-price spiral. Workers, particularly at the low end of the income distribution, have been squeezed by the high inflation of the last two years – in part, the result of wealthier people working from home and ordering too much stuff from the internet. Now, just as they are starting to claw this back through higher pay (and inflation is eroding the value of higher-income households’ accumulated savings), the authorities are threatening to crush wage pressures with a new recession. Maybe it would be better to let the dynamic play out, particularly if it is just a shift in the wage level (a reduction in margins) rather than the start of a new high-inflation era.

Wage price spirals
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