Employees prepare orders at ‘Wok to Walk’ restaurant in the Soho district in London, UK, on Friday, Sept. 30, 2022. UK retailers are facing a mortgage time bomb, with rising interest rates set to have twice the impact on consumer finances as the recent surge in utility bills, according to a Deutsche Bank analyst. Photographer: Jose Sarmento Matos/Bloomberg via Getty Images
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For workers struggling with the soaring cost of living, the idea that rising wages are concerning has always seemed laughable. But they had some policymakers and economists worried last year.
Minutes from the U.S. Federal Reserve’s March 2022 meeting showed unease that “substantial” wage increases would fuel higher prices.
In the U.K. the discussion was even more blunt, with Treasury officials publicly saying there was an inflationary risk from workers expecting wages to keep up with price rises. Bank of England Governor Andrew Bailey even went so far as to call for “restraint in pay bargaining” (and Germany’s finance minister made a similar plea).
The experts were worried about a so-called wage-price spiral. This occurs when workers expect inflation to keep rising, so demand — and achieve — higher salaries to keep up with price rises. Businesses then raise the prices of goods and services to cover higher labor costs, at the same time as workers have more disposable income to increase demand. This creates an inflationary loop, or in the language of economists, “second-round effects.”
This is argued to have happened in the 1970s, when inflation hit 23% in the U.K. and 14% in the U.S. in 1980.
But while concerns this time around aren’t totally gone, what’s being discussed more frequently now is the fact that a wage-price spiral has not occurred in the 18 months or so that inflation has been running red-hot in much of the world.
The European Central Bank’s March minutes, released Thursday, say wages have “had only a limited influence on inflation over the past two years.” Treasury Secretary Janet Yellen has also said she doesn’t see a wage-price spiral in the U.S.
And at the International Monetary Fund’s spring meetings session, the group’s chief economist, Pierre-Olivier Gourinchas, told CNBC it’s not something he is worried about in relation to the global economic growth outlook.
“What we’ve seen in the last year is prices rising very rapidly, but wages have not increased nearly as much, and that’s why we have a cost of living crisis,” Gourinchas said, after noting that core inflation remained high in many countries and in some cases was increasing.
“We should expect wages to catch up eventually and people’s real income to recover,” he said. Real income refers to wages adjusted for inflation, reflecting changes in purchasing power.
But the increase doesn’t present a risk because “the corporate sector has been sitting on pretty comfortable margins,” Gourinchas continued. Businesses’ revenues “have risen faster than costs, and so margins have room to absorb rising labor costs.”
The ECB’s March minutes say their analysis found the “increase in [corporate] profits had been significantly more dynamic than that in wages.”
There has also been increased discussion about how those corporate profits are contributing to inflation.
In a recent note, economists at ING looked at Germany, where inflation is increasingly a demand-side issue. While cautioning that so-called “greedflation” cannot be proven and there are variations by sector, they wrote that there are signs companies have been hiking prices ahead of the rise in their input costs, and that “from the second half of 2021 onward, a significant share of the increase in prices can be explained by higher corporate profits.” They call this a profit-price spiral.
The president of the Netherlands’ central bank, Klaas Knot, in December urged companies to raise wages for workers and said that 5%-7% pay rises in sectors that could afford it, combined with government energy bill support, would help balance the effects of inflation rather than fueling it.
Kristin Makszin, assistant professor of political economy at Leiden University, agrees. She told CNBC that while both wages and prices are rising, we can’t ignore external factors driving up wages (including the tight labor market) and prices (such as supply shortages).
“Since the Global Financial Crisis, wages have not recovered,” she said. In the U.S. for example, an annual wage increase of around 3.5% would be considered positive, accounting for 2% inflation and 1.5% productivity growth, but it has lagged behind this, Makszin said.
“It’s not that a wage-price spiral couldn’t happen, but it’s low on the list of concerns versus the factors we know are problematic,” she said. These include a potential downward low-wage-productivity spiral — when wages aren’t sufficient to get people back into the workforce or areas where they are needed, dampening productivity and therefore economic growth.
A key mechanism that would fuel a wage-price spiral, workers’ bargaining power, has been weakened because unions have less power than in the 1970s, Makszin added.
But with a tight labor market, people can just refuse to work — and that’s an area policymakers need to address, she said. “In sectors like U.S. hospitality, wages have increased dramatically, but that was correcting for many decades of low-paid work when labor was replaceable … it could be viewed as compensating for long-term wage stagnation,” she continued.
The country that is the “most vulnerable developed market economy” when it comes to a wage-price spiral is the U.K., according to Alberto Gallo, chief investment officer at Andromeda Capital Management.
Figures published this week showed U.K. wage growth slowed less than expected in the three months to March 2023, rising by 6.9% in the private sector and 5.3% in the public sector. Meanwhile, inflation remains above 10%, ahead of 7.8% in Germany and 5.3% in the U.S.
The risk, Gallo said, is from a mix of structural factors that contribute to stagflation. While low- and middle-income households are struggling with the soaring cost of food and other basics and higher rates are eroding people’s purchasing power in a highly-leveraged housing market, the central bank is actually keeping real rates — interest rates adjusted for inflation — at the most negative level in developed markets.
Meanwhile, the British pound is weak — and 50% of the country’s goods are imported — and foreign labor has been restrained by Brexit.
“We’re coming from a period where real wages have been stagnant for a long time and high inflation is finally pushing workers into strong renegotiations,” Gallo said. “But if you let interest rates go down against inflation and in effect weaken, you have an inflation spiral. Core goods [inflation] has come down but core services are not coming down,” Gallo said.
Not the 1970s
Richard Portes, professor of economics at London Business School, told CNBC there is “no serious risk” of a wage-price spiral in the U.K., U.S., or major European countries, however. He also cited reduced union power in the private sector as a notable change from the 1970s.
“If you look at core inflation in the U.S., rentals, housing, have been driving that. That’s got nothing to do with wages — with rentals, it’s more sensitive to interest rate rises,” he added.
There is evidence — including from the IMF — that wage-price spirals aren’t common. The IMF research found very few examples in advanced economies since the 1960s of “sustained acceleration” in wages and prices, with both instead stabilizing, keeping real wage growth “broadly unchanged.” As with so much in economics, the idea that wage-price spirals even exist has also been challenged.
For Kamil Kovar, an economist at Moody’s Analytics, the scenario was always seen as a risk, not necessarily likely. But he, too, said that as time progresses it has become clear that it is not happening.
Wages are likely to increase fairly rapidly for Europe, but there’s “so much scope for wages to catch up with prices, to get to a spiral situation we would need something totally different to happen,” he said. The ECB expects real wage growth of around 5% this year.
Real wages in Europe are so much lower than before the pandemic they could increase another 10% without going into a “danger zone,” Kovar said; while in the U.S. they are roughly equal but exiting the risky zone.
When comparing the current situation to the 1970s, Kovar said there were some similarities such as an energy shock; back then it was in oil, whereas this time it is bigger and broader, impacting electricity and gas too. There has also been a more rapid drop in energy prices as this shock has subsided.
And again, he noted the ongoing growth in corporate profits and the absence of powerful unions as yet more factors for why this time it’s different.
“It’s an example of how we are slaves to our historical parallels,” he said. “We potentially overreact even if the underlying situation is different.”