The debate over high inflation often seeks to apportion blame between greedy corporations raising prices and irresponsible workers making unrealistic pay demands. But, much as many people enjoy the game of identifying culprits, the focus should be on resolving the problem.
With core inflation stubbornly hovering around 5 per cent in the US and eurozone, and significantly higher at 7.1 per cent in the UK, all these economies are experiencing an unhealthy wage-price dynamic. Companies raising prices have prompted workers to defend their pay levels and this has put further pressure on businesses to increase prices. It is a damaging ratchet, if not quite a wage-price spiral.
The causes of the ratchet differ slightly on either side of the Atlantic. In the US, a recent paper from Ben Bernanke, former Federal Reserve chair, and Olivier Blanchard, former IMF chief economist, convincingly argues that a shock to energy and food prices alongside high levels of spending on other goods sparked the inflationary process in 2021. It subsequently spread to other goods and services and to wages as everyone sought to limit their own pain in a world of high demand, low unemployment and record vacancies.
In Europe, the focus was initially even more concentrated on energy as wholesale gas prices jumped last year. That ensured that most employees experienced significant falls in their real wages. Nevertheless, their gains in nominal pay helped push prices higher across whole economies, spreading inflation far and wide. This demonstrates that falling real earnings do not necessarily protect against a wage-price ratchet if the initial shock is big enough.
On both sides of the Atlantic, therefore, there is little doubt that the latest levels of wage increases — 6 per cent in the US, 4.6 per cent in the eurozone and 6.5 per cent in the UK — are not consistent with getting inflation down to 2 per cent, the targets of all major central banks. These rates of growth must fall if inflation is to be tamed.
Over the past few days, central bankers have spoken about how they think the conflict between wages and prices will be resolved. Jay Powell, Fed chair, said wage growth was moderating from “highly elevated” levels a year ago. With headline inflation rates falling, “we want to see that process continue gradually”, he added, suggesting that time was a great healer.
Isabel Schnabel, executive board member at the European Central Bank, said she thought some catch-up in wages could be “absorbed, to a large extent, by firms’ profit margins, thus breaking the vicious circle between wages and prices”, although she warned that if wage rises went too far, that would result in more inflation.
These are possible outcomes. But once prices and wages become intertwined, they are hard to separate. And as Professor Wendy Carlin of University College London says, everyone should take heed of what the Bundesbank, that bastion of orthodoxy, said in its 1973 annual report after the Opec oil shock.
After “a year of hard struggle for more price stability”, it said the success of each country depended on “whether it is made easier or more difficult to pass on the higher prices [of oil]”. Faced with a potential wage price spiral or, as the Bundesbank put it, “the domestic struggle for the distribution of the national income”, it said its aim was “to restrict the scope for passing on the higher prices as far as possible from the monetary angle”. Blunt talk and tough action, but almost alone it succeeded in the 1970s battle against inflation.
It does not really matter, therefore, what caused the rapid rise in prices. But central banks need to be certain they have extinguished their wage-price ratchets before taking their foot off the brake. Interest rates will need to stay higher for longer, even if that proves to be too heavy-handed in retrospect.
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