Will wage growth keep inflation too high?

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Wages matter. Not just for living standards, but for the inflationary process. This week, I am going to do a deep dive into what we know about pay trends in the US, eurozone and UK. One chart completely destroyed my previous beliefs and made me reconsider my views. I love it when that happens because I know I’ve learnt something. Let me know something recently that made you stop and think. Email me:

Worrying about wages

There is little today’s central bankers like to do more than worry about excessive wage rises. This is not a criticism. With wages accounting for roughly 60 per cent of gross domestic product in the US, eurozone and the UK, rapid pay increases will ultimately drive rapid price rises.

As ever, definitions matter too. The eagle-eyed (most of you) will notice I did not define “rapid” in the previous paragraph, nor did I explain “ultimately” and nor did I clarify that the labour share in GDP is also very difficult to measure, particularly in the treatment of self employment income. So what follows is an attempt to do just that.

The easy bit

One simple part of the wage and inflation story is that when there are no shocks or adjustments, inflation will be stable and on target if pay is growing at roughly the rate of inflation plus productivity growth. This is not controversial. It is the amount of wage growth necessary to maintain a constant share of GDP going to workers (employees and the employment element of self employment).

If wage growth is lower than this level persistently, as it has long been in Japan and was in Germany before the pandemic, it can put downward pressure on inflation, leaving countries stuck in a low inflation trap. The 1970s wage price spirals show the opposite effect.

With productivity growth having been around 1 per cent a year since the global financial crisis across many advanced economies, annual wage growth of roughly 3 per cent is consistent with a 2 per cent target over time. Top central bankers often mention this, with Fed chair Jay Powell and deputy governor of the Bank of England, Sir Dave Ramsden, citing these sorts of figures in their latest press conferences.

The problem is that wage growth is difficult to measure, leaving a lot for interpretation. The data is often late (in the eurozone especially), can be distorted by the changing composition of the workforce (an influx of low wage jobs can seemingly depress wage gains), can be of poor quality (household surveys) and can differ conceptually (for example in whether it looks at just those moving jobs).

The chart below therefore takes a range of measures for the US, eurozone and UK creating a band of pay growth indicators. The blue line showing the “headline” rate is the most often quoted figure for each economy. Click on “Indeed” for the Indeed wage tracker, which measures wages in job advertisements (and hence only for job movers). That does not apply to everyone, but it is more up to date and consistent across economies.

From the charts, I think you can conclude the following:

  • Wage growth is still above the long-term level consistent with stable inflation everywhere

  • All US measures are declining rapidly to this target. There is evidence this is also true in the UK, but levels of wage growth are still very high

  • The eurozone headline data for the third quarter of 2023 is horribly out of date

  • Click on the “Indeed” button and you can see that there is more slowing of wage growth for new hires in all areas, which is a good leading indicator of wage trends. Levels of wage growth are still too high for long-term stable inflation

The catch-up

The big problem with the analysis above is that we are not in a long-term steady state. At the moment wages are also adjusting to the pandemic, the inflationary period and the energy crisis of recent years. It helps, therefore, to look not only at wage growth but also the level of wages compared with the level of prices, as I have drawn in the chart below.

The chart was not what I was expecting. For sure, US wage levels have kept up with prices (roughly) and they have fallen far behind in the eurozone. This was to be expected because inflation was more demand driven in the US and rapidly rising imported energy prices in 2022 required European consumers to take a real hit to their living standards. Russia’s invasion of Ukraine made Europe poorer both in absolute terms and relative to the US.

But look at the UK. This really surprised me and I had to check the figures carefully. Though Britain faced almost exactly the same shock as the eurozone, wages kept pace with prices and grew faster in relative terms than the US since the end of 2019. This is a much more inflationary dynamic and made me worry I have become too dovish recently about UK monetary policy and the labour market figures this morning did not help. It is especially surprising since the domestic narrative in Britain is that households are suffering a cost of living crisis and need a break.

The necessary productivity adjustment

Remember that in the long term, wages can rise by inflation plus productivity growth. The chart below gives a crude, but internationally comparable, estimate of productivity changes since the pre-pandemic period. Two things to note here are that there has been next to no growth in European GDP per employee since late 2019, which is considerably worse than US productivity growth although that is also far from strong. This suggests the US can sustain higher wage growth than Europe without generating inflation and explains much of the difference between the US and eurozone in the previous chart.

It is worth noting the big pandemic distortions in these figures because US companies laid people off during Covid, temporarily raising measured productivity levels because the low paid were more likely to lose their jobs, while Europe kept people attached to their employers while output tanked, lowering measured productivity.

The necessary terms of trade adjustment

Less than a year ago, the BoE chief economist Huw Pill got himself into hot water by saying bluntly that people had to accept they were “worse off” because the stuff the UK consumes from abroad, mostly energy, had become more expensive. He had to apologise because his choice of words suggested he was blaming the public for making his job harder. There is no doubt, however, that his economics was right. If a country’s imports get a lot more expensive, households or companies have to take a hit and if everyone tries to protect their real incomes or profits, inflation will persist.

The good news is that for Europe (eurozone and the UK), the huge terms of trade hit from imports becoming much more expensive compared with exports has disappeared as energy prices have fallen.

The recovery in Europe’s terms of trade implies the need for real wage cuts to stabilise inflation has gone for now, and the rise in America’s terms of trade suggests it could have a little more real wage growth without inflation. Remember, though, that in the US where trade is a small share of GDP, these effects will not be large.

What can we say about wages?

I think we can say the following:

  • The levels of wages and prices are more instructive than their current growth rates, so long as nothing was terribly out of kilter before the pandemic in late 2019

  • Everything looks consistent with stable inflation in the US and a little more real wage growth would be possible without stimulating inflation. Powell was right to say that the wage outlook appeared “OK”, “healthy” and “moving in the right direction” in his January press conference

  • Eurozone pay discipline has been awesome. That was necessary after Russia’s invasion of Ukraine, and now everyone should relax a little. There is no longer a need for pay to have grown less than prices. This is in line with the ECB’s forecasts and an important speech last week from Phillip Lane, chief economist. The ECB forecasts suggest eurozone wage growth can be above 4.5 per cent in 2024, above 3.5 per cent in 2025 and still above 3 per cent in 2026, without harming the disinflation process. Pay recovery is needed

  • The UK is on the edge. The improvement in the terms of trade makes the real growth of pay since 2019 sustainable, but there is little room for more “catch-up” without big productivity gains. The BoE needs to see pay growth coming down fast

What I’ve been reading and watching

A chart that matters

This chart matters because there is next to no action. A huge amount of ink was spilled last week on whether the seasonal adjustment factors of the US consumer price index would change and indicate more inflation in recent months. As the chart of seasonally adjusted monthly price changes before and after revisions showed, they did not.

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