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Wage-price spirals are far scarier in theory than they are in practice

A wage price spiral It’s an inflationary nightmare. It refers to price spikes—perhaps due to a sudden shock or a policy misstep, or both—and wages race to keep up with them, which in turn leads to more price increases and more Wages rise, and so on in such a vicious circle. The world economy seems to be living in this horror: American hourly wages rose about 6% last year, the largest annual increase in four decades. In the UK, annual wage growth, excluding bonuses, is around 7%. On June 14, when the Fed opted to keep rates on hold after 10 straight hikes, its chairman, Jerome Powell, warned that he was watching wage trends as a gauge of whether the central bank might resume raising rates in July of a test.

But the dangers that arise in nightmares often bear little resemblance to real-world threats worth worrying about. The world’s troubles with inflation over the past two years seem to point to a similar conclusion about wage-price spirals: they are a caricature of what happens in economies with inflation problems.

The historical parallel often mentioned in discussions of the wage-price spiral is the 1970s. Price and wage inflation appeared to interact during that decade, as suggested by the spiral framework. Every spike in general price inflation was followed by a spike in wage inflation, followed by more price inflation—and on and on. But the evidence for the existence of the 1970s as a spiral is flawed. The recurring inflationary waves stemmed more from successive oil price shocks (1973 and 1978) than from preceding wage growth. In terms of simultaneous wage and price movements, this mirrored the practice of unions at the time linking wages to the cost of living, thus ensuring a ratchet effect. The spiral is a feature of the contract, not a proof of economic concept.

Late last year, a group of economists International Monetary Fund Interrogating historical records created a database of wage price spirals in advanced economies dating back to the 1960s. Applying a fairly low standard—they looked for accelerated consumer price inflation and nominal wage increases in at least three of four consecutive quarters—they identified 79 such events. But several quarters of high inflation aren’t that scary. Years are even more terrifying. Judging by this longer criterion, International Monetary Fund Economists drew a more optimistic conclusion: the “vast majority” (they omitted the exact percentage) of a short-term spiral was not followed by a sustained acceleration in wages and prices.

In a March report, economists Gadi Barlevy and Luojia Hu of the Federal Reserve Bank of Chicago took a closer look at the role of wages in current inflation. They focused on “nonhousing services,” a category that covers everything from car washes to medical exams, which Mr. Powell often cites as a useful metric because it is so closely tied to wages. Mr Barlevy and Ms Hu conclude that wages do help explain this part of inflation: Nominal wage growth has largely outpaced productivity growth over the past year. Faced with cost tightening, service providers will naturally want to raise prices.

However, the spiral theory claims that not only wages matter, but they also predict future inflation trends. For that matter, economists at the Chicago Fed found that the relationship is one-way: inflation helps predict changes in labor costs, but changes in labor costs do not predict inflation. In other words, service providers raised prices before rising wage costs hit the bottom line. Mr Barlevy and Ms Hu argue that employers may have gotten ahead of themselves by anticipating the impact of the tight labor market. This makes wages a lagging indicator of inflation rather than a leading one.

Adam Shapiro, an economist at the San Francisco Fed, was more critical of wage concerns. In a May report, he isolated the unexpected change in wages, arguing that rising labor costs were only a small driver of inflation in non-housing services and insignificant in broader inflation. Like his colleagues in Chicago, he concluded that wage growth follows inflation.

That doesn’t mean wage-price spirals are an out-and-out myth, as some overzealous commentators have written.as International Monetary FundThe study points out that serious spirals can occur; it’s just that they’re very unusual. If inflation remains high for a prolonged period, people may begin to view rapidly rising prices as a fact of life and incorporate this assumption into their salary requirements. This process may have already begun in the UK.

But in the US, what has been striking over the past two years is that despite price pressures, inflation expectations have remained relatively benign. In a paper written last month for the Brookings Institution think tank, former Fed chairman Ben Bernanke and former Fed chief economist Olivier Blanchard Olivier Blanchard) International Monetary Fund, breaking down the drivers of inflation during the pandemic. They concluded that the triple shock (surge in commodity prices, high commodity demand and supply shortage) was the main reason for the overshooting of inflation since 2020. There is little evidence that inflation itself triggers higher wage demands. Wages go up simply because demand for workers outstrips supply.

dreaming spiral

Wages and prices can be driven up by the same force: excess spending in the economy coupled with shortages of products and the workers to produce them. An overheating economy is a cause for concern, whether or not prices and wages interact.

For their part, Bernanke and Blanchard argued that an overheated labor market could stoke inflation as the pandemic shock fades. To stop this, central banks need to ensure that demand for workers cools down. The fear of a self-sustaining spiral is worth losing sleep on only if inflation persists after the labor market rebalances.

We are hiring (June 12, 2023). The Economist is looking for UK economics writers based in London. For more information and how to apply, click here.

Read more from our economics column Free Exchange:
A Flawed Argument for Central Bank Digital Currencies (June 8)
What would the perfect carbon price look like? (June 1)
What performance-enhancing stimulants mean for economic growth (May 25)

Plus: How the Free Swap column got its name

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