Wage-price spirals are a risk to keep in mind

The year 2022 was characterized by an increase in inflation in most of the developed world, and those who follow the markets may have seen the word “wage-price spirals” thrown out multiple times when speaking about the labor market in the United States. I, too, talked about it this Summer.

Indeed, high inflation and a tight labor market is a terrible combination, as it creates room for a wage-price spiral to happen. Hence why, despite the CPI coming out lower than expected in both October and November, the Fed not only did not pivot, but reinforced the idea that they need to see unemployment going up for them to even think about pausing.

A wage-price spiral is a self-reinforcing cycle of wage increases and price increases that can lead to higher inflation and economic instability. It starts when workers demand higher wages to keep up with rising prices, which then leads to higher prices for goods and services as businesses try to maintain their profit margins.

There are a few ways that wage-price spirals can get started. One common trigger is when there is an increase in the cost of living, such as when the price of oil or other raw materials increases. This can lead to higher prices for goods and services, which in turn prompts workers to demand higher wages to keep up with the cost of living. Another factor that can contribute to wage-price spirals is when there is a tight labor market and a shortage of skilled workers. In this case, employers may be willing to offer higher wages to attract and retain employees, which can then lead to higher prices for goods and services as businesses try to maintain their profit margins.

Generally speaking, though, wage-price spirals can be difficult to detect and to address, as they often develop gradually over time. In addition, different economic and political factors can influence the likelihood and severity of wage-price spirals, making it difficult to predict when they may occur and how they may impact the economy.

There are several ways that governments and central banks can try to prevent or mitigate wage-price spirals:

  • Implementing monetary policies, such as raising interest rates, to reduce demand and curb inflation;
  • Implementing fiscal policies, such as increasing taxes or decreasing government spending, to reduce demand and curb inflation;
  • Implementing wage and price controls to prevent rapid increases in wages and prices;
  • Implementing measures to increase productivity and efficiency, which can help to keep prices down.

Raising interest rates may be seen as the best way to fight the formation of a wage-price spiral because it reduces demand and curbs inflation by making the act of saving money more attractive than spending it: this can lead to a decrease in demand for goods and services, which can help to keep prices from rising too rapidly. However, the effects of raising interest rates may take some time to be felt, and it may be difficult to accurately predict how they will impact the economy.

Inducing a recession may also be seen as a way to fight the formation of a wage-price spiral: indeed, when there is less demand for goods and services, businesses may be less able to increase prices, which can help to keep inflation in check. In addition, when the economy slows down, the labor market may become less tight, which can reduce the pressure on wages to increase.

That’s coherent with the Phillips curve, which shows that without a beneficial supply shock, lowering inflation requires a period of high unemployment and reduced output. It’s worth noting that despite low unemployment drives inflation by wage adjustments, it’s never the other way around: low inflation doesn’t cause high unemployment, nor does high inflation cause low unemployment.

Several papers have examined the Phillips curve in a quantitative way, and their results are often summarized in a number called “sacrifice ratio”, which represents the percentage of a year’s real GDP that must be forgone to reduce inflation by one percentage point. Although the estimates for the sacrifice ratio vary substantially, the typical one is about 5: that is, for every percentage point that inflation has to fall, 5% of one year’s GDP must be sacrificed. What’s interesting about this ratio is that it can be expressed in terms of unemployment as well: Okun’s law says that a change of 1% in the unemployment rate translates into a change of 2% in GDP. Hence, reducing inflation by 1% requires about 2.5 percentage points of cyclical unemployment.

This is why, despite inflation slightly declining on a YoY basis, the Fed continued to hike, reinforced its hawkish stance, and moved the focus on the strong labor market: it’s not that they want to induce a recession, but it’s very difficult to deal with inflation if the unemployment stays this low. Furthermore, the tighter the labor market, the higher the bargaining power of employees regarding wages, which further adds to the possibility of a second-wave of inflation.

However, the effects of a recession may be difficult to predict and may last for an extended period of time, hence why policymakers may be hesitant to use this approach to address wage-price spirals, especially if there are other available options that may be less disruptive to the economy.

There is also the possibility of a painless disinflation, which is now referred to as a “soft landing”, that has two requirements. First, the plan to reduce inflation must be announced before the workers and firms that set wages and prices have formed their expectations. Second, the workers and firms must believe the announcement, because otherwise their expectations of inflation won’t fall. If both the requirements are met, the announcement will quickly shift the short-run tradeoff between inflation and unemployment downward, allowing lower inflation without the need for higher unemployment.

According to the theory of rational expectations, under a credible policy the costs of reducing inflation may be much lower than estimates of the sacrifice ratio suggest, because if policymakers are credibly committed to reducing inflation, rational people will understand the commitment and lower their expectations of inflation. This view is particularly controversial, as there is no way to know whether the public will view the announcement of a new policy as credible: the “pivot crowd” proved that several times this year.

If left unchecked, the consequences of a wage-price spiral can be significant for the economy and for individual households and businesses. Some potential consequences include:

  • Higher inflation: A wage-price spiral can lead to higher inflation, which can erode the value of money and make it harder for households and businesses to plan for the future, as it becomes more difficult to predict the future value of money.
  • Economic instability: A wage-price spiral can lead to economic instability, as it can be difficult for businesses and policymakers to predict and respond to the changes in wages and prices that are occurring. This can make it more difficult for businesses to make investments and plan for the future, and can lead to slower economic growth.
  • Negative impact on fixed incomes: Inflation can be particularly harmful for people on fixed incomes, such as retirees or those on social security, as it can erode the purchasing power of their money over time.
  • Decrease in the value of currency: A wage-price spiral can also lead to a decrease in the value of a country’s currency, as investors may be less willing to hold it due to concerns about inflation. This can make the country’s exports more expensive for foreign buyers, and thus may make foreign investors less willing to hold the country’s currency.
  • Negative impact on international trade and investment: The decline in the value of a country’s currency can also have negative consequences for international trade and investment, as it can make the country’s exports less competitive and may discourage foreign investment.

There have been several instances in history where wage-price spirals have had significant impacts on the economy.

One example is the stagflation of the 1970s, when the United States experienced high inflation and slow economic growth. This was partly due to wage-price spirals that were triggered by increases in the cost of oil and other raw materials, as well as by a tight labor market and wage increases. The current macroeconomic environment closely resembles that period.

Another example is the hyperinflation that occurred in Germany in the early 1920s, which was triggered by the German government’s decision to finance the First World War and the subsequent reparations required by the Treaty of Versailles by printing more money. This led to rapid increases in the money supply and, as a result, to high inflation and a significant decline in the value of the Papiermark.

In more recent years, wage-price spirals have been less of a concern in developed countries, as central banks have apparently become more adept at using monetary policy to manage inflation and maintain economic stability. However, it remains a potential risk in developing countries, where economic and political conditions may make it more difficult to implement effective policies to prevent or mitigate wage-price spirals.

The problem is that as the developed countries experienced a wave of roaring inflation once again after many years, this risk is becoming real once again. There have been already headlines of wage adjustments in Europe and the United States, and unless the unemployment starts to climb higher, the wage-price spiral will shift from becoming a risk to becoming a reality. Even more if China actually opens, as that would fuel a big increase in raw materials’ cost.

In conclusion, wage-price spirals are important economic phenomena that can have significant consequences for the economy and for individual households and businesses. By understanding how they work and how they can be prevented or mitigated, it is possible to promote economic stability and prosperity. However, it is also essential to recognize that wage-price spirals can be difficult to detect and address, and that different economic and political factors can influence their likelihood and severity.

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