Debates about high inflation often try to assign blame between greedy companies raising prices and irresponsible workers making unrealistic wage demands. But while many people enjoy the game of figuring out the culprit, the focus should be on fixing the problem.
With core inflation stubbornly hovering around 5% in the US and Eurozone, and notably above 7.1% in the UK, all of these economies are experiencing unhealthy wage-price dynamics. Companies raising prices prompt workers to defend their wages, which further forces businesses to raise prices. That’s a destructive ratchet, if not for wage-price spirals.
The reasons for the ratchet are slightly different on both sides of the Atlantic.In the U.S recent papers From former Federal Reserve Chairman Ben Bernanke and former IMF Chief Economist Olivier Blanchard convincingly argue that shocks to energy and food prices, along with high spending on other commodities, set off the inflationary process in 2021 . It then spread to other goods and services and wages as everyone tries to ease their pain in a world of high demand, low unemployment and record job openings.
In Europe, the initial focus was more on energy as wholesale gas prices surged last year. This has ensured that real wages for most employees have fallen substantially. Still, the rise in their nominal wages helped drive up prices across the economy, spreading inflation widely. This suggests that, if the initial shock is large enough, a decline in real incomes is not necessarily resistant to wage-price ratcheting.
So, on both sides of the Atlantic, there is little doubt that the latest levels of wage growth – 6% in the US, 4.6% in the euro area, and 6.5% in the UK – are in line with bringing inflation down to 2%, the target of all major central banks. . These growth rates have to come down if inflation is to be contained.
Over the past few days, central bankers have spoken about how they think the conflict between wages and prices will be resolved. Federal Reserve Chairman Jay Powell said wage growth was slowing from “high” levels a year ago. With headline inflation falling, “we would like to see this process continue gradually,” he added, suggesting that time is a good medicine.
ECB executive board member Isabel Schnabel said she think wages have risen could be “largely absorbed by corporate profit margins, thereby breaking the vicious circle between wages and prices”, although she warned that if wages rose too far, it would lead to more inflation.
These are possible outcomes. But once prices and wages are intertwined, it is difficult to separate them.As Professor Wendy Carlin from University College London puts it, everyone should heed what the bastion of orthodoxy, the Bundesbank, said in its statement 1973 Annual Report After the OPEC oil shock.
After “a year of tough struggles to achieve price stability”, it said each country’s success depended on “making it easier or more difficult to pass on (oil) price increases”. Faced with a potential wage-price spiral, or, as the Bundesbank puts it, a “domestic struggle over the distribution of national income”, it said its aim was to “limit as much as possible the scope for passing on higher prices to Germany’s ‘currency perspective'”. Admittedly, tough action, but it almost alone succeeded in the fight against inflation in the 1970s.
Therefore, it doesn’t really matter what caused the rapid price increase. But central banks need to be sure they have removed the wage-price ratchet before they let off the brakes. Interest rates need to stay higher for longer, even if it turns out to be too draconian in hindsight.
chris.giles@ft.com