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Is the world economy entering a wage-price spiral?

October 16, 2021

TThe rich world is used to wages and prices growing slowly. In the decade following the global financial crisis, inflation rarely exceeded central bank targets, and wages did not seem to grow much faster. The purchasing power of the average hourly wage in the UK, Italy and Japan was about the same at the start of the pandemic as it was in the mid-2000s. The fact that from 2015 to 2019 American wage growth averaged 2.9% while average inflation stayed below 2% seemed like a rare triumph.

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The recovery from the pandemic has brought about a surprising change: prices and wages are rising. American hourly wages rose 4.6% through September, while consumer price inflation of 5.4% more than canceled out those gains. In Germany, inflation has reached 4.1% and the largest public service union is calling for a 5% pay increase. In Japan, wages and prices even rose slightly.

The reasons for higher prices are obvious: the rampant demand for goods meets supply chain bottlenecks and energy prices have skyrocketed. Wage growth is more mysterious. In most places, employment is lower than it was before the pandemic. However, workers seem unwilling or unable to accept the many jobs on offer. The labor shortage may reflect the difficulty of switching between jobs and places when economies go through unusual adjustment. Fear of the virus and the ongoing impact of government support on household incomes could keep workers idle. The pandemic may even have caused some people to put family and leisure above their careers.

An unclear understanding of what is driving wages higher makes life harder for central banks. Most have argued that high inflation is temporary. But excessive wage increases could be the next factor driving prices up, especially if workers demand higher wages in anticipation of future increases in the cost of living – insurance that exacerbates exactly what they are trying to offset.

To avoid prolonged inflation, a combination of three things must happen. Firms could absorb higher wages in their margins instead of raising prices. Productivity growth could make higher real wage increases sustainable. Or idle workers could return to the labor force and dampen wage growth.

In the popular notion, the workers’ share of the economic pie has room to grow at the expense of profits. However, recent research suggests that labor’s share of business value added has actually remained fairly stable in most rich countries over the past few decades. We estimate that it has already increased by an average of one percentage point during the pandemic in the large, rich countries. There may not be much room for further increases.

Higher productivity growth is a legitimate hope. Output per worker in America has increased since the pandemic began. The digitization brought about by the pandemic is expected to increase the standard of living, especially if it reduces the need to live near expensive cities in order to get good jobs. The problem is that time lags make it difficult to base policy on productivity trends. They are difficult to measure in real time, and it takes about 18 months for central bank decisions to fully feed into the economy.

This means that politics should focus on the labor supply. The recovery so far has been disappointing. There is surprisingly little evidence that the end of emergency programs like US expanded unemployment insurance and the UK vacation regime has increased the number of job seekers. However, if bank accounts run empty and the pandemic subsides, some void may reappear in 2022, causing a slowdown in wage growth. Monetary politicians should keep an eye on jobs even more than usual.

This article appeared in the Leaders section of the print version under the heading “Checks and Imbalances”

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