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Friday’s surprisingly strong non-farm payroll data confirm that the US labour market is still strengthening despite tightening financial conditions. The country’s unemployment rate, at 3.4 per cent, is now the lowest for 53 years. After the FOMC’s decision to hike only 25 bp earlier in the week and dovish-sounding press conference given by Jerome Powell, market participants assumed that the Fed was close to reaching its terminal rate soon possibly with one more small hike if any. Subsequently, the investment sentiment turned positive across risk assets including beaten-down tech stocks and cryptos. However, more than half a million new jobs generated in January led to a bond sell-off together with a sharp decline in equities as investors reassessed whether the Fed would keep interest rates high for longer. In order to stop interest rate hikes, the Fed not only needs to bring inflation down, but it also needs to have the labour market to cool off. As long as the labour market stays tight, the momentum of consumption would not abate and inflation remains elevated.
On November 18th in 2022 the German trade union IG Metall, which includes metal and industrial sectors and covers 9.2% of total German employees, agreed with a new pay deal. The new settlement foresees wage increases of 5.2% in June 2023 and 3.3% in May 2024. In addition, there will be one-time payments of €1500 in February 2023 and February 2024. German wage deals tend to provide the most forward-looking outlook for wage in Europe because they set a typical duration of up to two years. The settlement runs until September 2024, giving employers much-needed certainty about one important aspect of their input costs. This is towards the upper end of the previous expectations based on past wage deals and is close to the outcome in 2008. Therefore, wage growth in Germany is expected to rise markedly to reach 3.5% by the end of 2022 and this year. In particular, the relatively strong increase in base pay, which lasts longer, could be more inflationary in the medium-term, as it permanently raises firms’ labour costs. According to UBS, 1% higher wage growth implies around 20~30bp higher inflation in Germany. This is hardly keeping pace with inflation (11.6% in October) but looks generous considering the numerous headwinds faced by businesses.
Is it a myth that wage-price spirals cause inflation – that higher prices lead to higher wage demands, which beget further higher prices and then higher wages again and again? Prices and wages could start feeding off each other and accelerate, leading to a wage-price spiral dynamic. In theory, inflation is a monetary phenomenon, of too much aggregate money expenditure chasing too few goods. According to Milton Friedman, the ultimate source of the increase in price has been an increase in monetary demand. It is not possible to get further inflationary pressures from wage demands alone unless monetary forces accommodate them. Major supply-shocks to energy and food, as well as excessive monetary stimulus, have driven up inflation during the pandemic. However, sustained inflation can only come from excessive growth in money expenditures, requiring either a rapidly growing money supply or excessive money velocity. For a given level of total money expenditure in the economy (aggregate demand), wage hikes don’t generate price rises across the board. Historically, economies in which real wages have been flat or falling like now did not tend to show a subsequent wage-price spiral. Given that inflationary shocks are originating outside the labour market, falling real wages are helping to slow inflation, and monetary policy is tightening more aggressively, the chances of persistent wage-price spirals emerging appear limited.
Policymakers worry a great deal about wage inflation these days. The relationship between wage growth and unemployment is best described by the Phillips curve; spare capacity (unemployment) in the labour market is a key driver of pay in the short run although productivity growth drives real wage growth in the long run. The lower unemployment grants workers a cyclical boost to their bargaining power to extract higher pay as employers struggle to find or retain suitable staff. This Phillips curve relationship has changed recently, with G7 pay growth now higher than it was before 2020 despite unemployment being only slightly lower. From 2012-2019, the G7 unemployment rate only varied between 4% and 8%. Given the limited changes in wage growth, the Phillips curve appears to be flat, i.e., there was hardly a relationship between unemployment rates and wage growth. The flatness of the Phillips curve was widely reinforced by low inflation expectations due to factors including demographics, slowing productivity growth and strong demand for safe assets.
On the contrary, wage growth exhibits a more convex relationship with unemployment in the wake of the pandemic. What is behind the apparent resurrection of the Phillips curve relationship between unemployment and wages? One factor is driven by an increase in mismatches between employers seeking workers and those seeking work wrought by the pandemic. Lockdowns and re-openings caused big swings in the sectoral make-up of demand for goods and services, and thus in demand for labour. For example, some workers are hesitant to re-engage because of ongoing health concerns and difficulties finding child and family care. Shortages in sectors like hospitality were particularly acute as January non-farm payrolls show that the leisure and hospitality sector registers the biggest rise. IMF reports that shifting worker preferences regarding conditions and types of work as well as inactivity among older workers (“excess retirements”) explain some of the persistent mismatches in the US and UK since the breakout of the pandemic. A rise in retirement alone accounts for more than half the 3.5 million labour shortfall in the US. In effect, unemployment rates are understating the true degree of tightness in labour markets, which results in a higher wage growth in 2020-2022. In addition, high inflation forced households to ask for higher pay to help compensate for the increase in the cost of living even for the similar unemployment rate prior to the pandemic.
By many metrics, labour markets look tight in advanced economies where inflation has risen most. Unemployment rates are back to pre-pandemic levels and job vacancies have risen sharply. The US data exemplify the tightness of the labour market as there are 1.9 openings available for every unemployed worker. Although the recent trend indicates a declining job openings due to tightening financial conditions and weak consumer demands, the ratio of job opening to unemployment remains too high to alleviate wage pressure. The tight labour market has resulted in a big boost in worker wages, but they nonetheless have failed to keep up with inflation. Thankfully, the wage growth in the lowest income quartile has outpaced the rest after suffering no real wage growth in the past several decades. In fact, real wages for the bottom 40% of workers have actually increased since 2020. Although some are concerned with insufficient skilled workers and their demand on higher wages, data suggest that the real squeeze in the labour market takes place in the segment of low qualified jobs in pandemic-affected sectors such as leisure, hospitality and retail trade supported by the higher wage growth. BIS research finds that historically wage increases in leisure and hospitality have been short-lived and spillovers to wages in other sectors limited. Perhaps the cost-of-living squeeze and expiration of pandemic-era aids will eventually induce labour market dropouts to re-enter the labour force, raising the participation ratio to the pre-pandemic level and relieving the wage pressure.
As a consequence of the unexpected surge in prices, real wages are falling in many countries, slashing purchasing power. According to the new report by ILO, real global wage growth fell to negative 0.9 per cent in the first half of 2022. This is hurting people everywhere. If inflation is not contained, these problems will only become worse. In the fight against rising prices, it is also essential that fiscal policy works hand-in-hand with monetary policy. As we witnessed a financial fiasco from the UK’s mini budget in October 2022, misaligned fiscal policy could derail the economic recovery and destabilize the financial market. Therefore, policy support to shield households and firms from the energy shock should be targeted and temporary without adding to inflationary pressures and increasing public debt burdens. In the current difficult and uncertain times, policy has once again a crucial role to play as in the outset of the pandemic. The worst mistake for policymakers is that persistent mismatches are combining with expectations of sustained high inflation, which are becoming embedded in wage. This cocktail could leave wage growth elevated even as economies weaken, and unemployment rates rise. Goal of policy response is to break such a wage-price spiral and reset inflation expectations. If monetary policy is not tight enough, inflation will persist, and maybe get entrenched in people’s expectations, so it will become harder to reduce later.
Whether inflation enters a persistently higher regime will depend on labour market developments, and on whether a wage-price spiral emerges as the global supply-chain gradually normalizes. The likelihood of an economy entering a wage-price spiral depends on macroeconomic conditions. Without higher aggregate demands, if inflation expectations are too high, workers would demand higher pay. Therefore, a key argument for central banks to urge wage restraint is to anchor inflation expectations. Otherwise, this could signal a shift to a regime of persistently higher inflation accompanied by a de-anchoring of inflation expectations. The current environment does not look conducive to a wage-price spiral as the correlation between wage growth and inflation has declined over time albeit the recent pickup. Nevertheless, fighting inflation must be the top policy priority of central banks. Although there are tentative signs of lower commodity price inflation, falling shipping costs and easing product shortages, central banks around the world are fully aware of the risk of de-anchoring. In the absence of a forceful policy response, the current inflation may well feed into wage- and price-setting decisions and heighten the risk of de-anchoring. Hence, central banks are determined to continue to increase interest rates to curb inflation and anchor inflation expectations until necessary even if it means a sharp cooling of the economy and rise in unemployment. The evidence from similar historical episodes suggests that an appropriate monetary policy response can contain the risks of a subsequent wage-price spiral in the current circumstances to very low levels.
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