With inflation rising across advanced economies, eyes are turning to wage developments in trying to understand whether more long-lasting inflationary pressures are mounting. The recovery in oil prices since Spring 2020, the reopening of the economy this year, and persistent bottlenecks as supply is trying to keep up with the recovery in demand have led to some of the highest inflation figures seen in the last decade. To what extent this is a temporary surge or may become more long-lasting is already under debate (e.g. Ball et al. 2021, Brignone et al. 2021, Gómez-Pineda et al. 2021). The outcome will crucially depend on how labour costs will respond (Lagarde 2021) and whether any wage-price spirals may materialise (Powell 2021).
Our research finds that the link between labour cost and price inflation is state-dependent (Bobeica et al. 2020, 2021a). With less-anchored inflation expectations and higher inflation, changes in labour costs are more likely to generate inflationary pressures. We refer to labour costs as being wages adjusted for productivity developments, as this measure is indicative for the input cost pressures faced by firms. Figure 1 shows that the pass-through is systematically higher in periods when the inflation rate (adjusted for long-term inflation expectations) is higher than the historical average. This lower pass-through when inflation is low can be caused by downward wage rigidities and lower inflation persistence in a low-inflation environment (Taylor 2000, Daly and Hobijn 2014). Another argument is linked to the search intensity of consumers. Concretely, at low levels of inflation, a large fraction of buyers observe a single stable price. In that case, any given shock would increase price dispersion sharply, which would increase the search intensity of consumers, thereby reducing firm market power and limiting the ability of firms to pass on the cost increase to prices (Head et al. 2010).
Figure 1 Pass-through from labour cost to price inflation under two inflation regimes
Source: Bobeica et al. (2020, 2021a).
Note: We estimate an SVAR identified with a Cholesky factorization and containing quarterly data for three variables, namely the annual growth rates of (i) real GDP, (ii) a measure of labour cost defined as wages adjusted for productivity, and (iii) the core PCE price index (for the US) and the GDP deflator (for euro area countries). To measure wages, we use hourly labour compensation in the non-farm business sector for the US and compensation per employee for euro area countries. The two nominal variables, labour cost and price inflation, are expressed as deviations from long term inflation expectations. Sample: 1960Q1-2018Q3 (for the US) and 1985Q1-2018Q1 (for the euro area). High/low inflation refers to their level compared to the historical average.
Beyond inflation, the wage–price pass-through also depends on the nature of the shock hitting the economy. When the economy is predominantly hit by demand-type shocks, it is more likely that the increase in wages above productivity is passed on to inflation than when the economy is predominantly hit by supply-type shocks such as technology shocks (see Figure 2). One explanation for this is that demand shocks typically tend to be more persistent than supply shocks. Moreover, the link between labour cost and price inflation may also be stronger when positive demand shocks dominate, as these shocks raise the share of higher income consumers with lower demand elasticity. This in turn raises firms’ ability and power to pass through cost increases to prices (e.g. Bergin and Feenstra 2001). A wage–price pass-through occurs not only under demand shocks, but also tends to be significant for monetary policy shocks and shocks originating in the labour market (such as labour supply and wage mark-up shocks), yet the magnitude of such pass-through tends to be smaller than under demand shocks.
Figure 2 Amplification of price inflation response due to the labour cost channel
Source: Bobeica et al. (2020, 2021a).
Note: Blue square shows a significant transmission of shocks via labour costs. A counterfactual impulse response function (IRF) for inflation is computed whereby after the occurrence of a certain shock the labour cost channel is shut down. By comparing such counterfactual IRF with an unrestricted IRF one can gauge how much labour costs are contributing to the transmission of shocks to inflation. The blue squares indicate the quarters following a certain shock where labour costs create a significant amplification of the shock in domestic inflation, i.e. the cases where the median counterfactual IRF lies outside the 68 percent posterior uncertainty band of the unrestricted IRF.
Figure 3 Pass-through and trade openness in the US
Source: Bobeica et al. (2021a).
Note: The pass-through refers to the long-run (40 quarter) value; the change in pass-through was inferred based on 60 quarter rolling window estimations. Trade openness is defined as the ratio of imports plus exports over value added.
The pass-through from labour costs to price inflation may also be linked to secular trends beyond the realm of central banks. One such trend has been the rise in trade integration. Based on a novel dataset for the US economy covering 93 sectors between 1973Q1-2018Q3, we unveil a connection between the pass-through in US manufacturing firms and their degree of trade integration. Figure 3 shows that in industries where the pass-through decreased over time, trade openness increased faster. Moreover, the figure also suggests that it is not only the change in trade openness that could have a bearing on the pass-through, but also its level. The pass-through of labour cost to price inflation namely fell in sectors where the level of trade openness was higher.
Finally, trends shaping the degree of firm competition also played a role. In the US, the rise in market power can be one of the factors behind the observed decline in pass-through from labour cost to prices. Rising markups have been concentrated among large international companies (e.g. Autor et al. 2017, Diez et al. 2018). These companies benefit from global networks of factors of production and are able to offset the impact of wage shocks. Figure 4 compares developments in our estimated labour cost pass-through with those in a measure of firm market power from DeLoecker and Eeckhout (2017) in the case of the US and from McAdam et al. (2019) in the case of the euro area. For the US, there is a very strong link between the decline in the pass-through from labour cost to price inflation and the evolution of the aggregate markup (in reverse scale). This co-movement is visible also in the euro area, where the pass-through from labour cost to price inflation has been more stable (see also the discussion in the Bobeica et al. 2021b) and there was no pronounced upward trend in market power (Cavalleri et al. 2019).
Figure 4 The link between market power and labour cost pass-through in the US
Source: Bobeica et al. (2021a).
Note: the solid series show the rolling pass-through estimate (at 40 quarter horizon) of a labor cost shock to price inflation based on a VAR estimation described above. For the United States the results are shown for a 30-year rolling window, for the euro area for a 20-year rolling window. The markup estimates are shown in reverse scale and based on De Loecker and Eeckhout (2017) and McAdam et al. (2019).
It is not only wages per se that need to be monitored at the current juncture; the strength of the link between labour costs and inflation also matters. This link crucially depends on the state of the economy. When inflation expectations are well anchored and supply shocks dominate, our findings show that the pass-through from labour cost to price inflation is more likely to be weak. These results have important implications for monetary policy as they would suggest that, provided inflation is low and expectations well anchored, accommodative policies are not likely to add to inflationary fears via the labour cost channel. However, the link between labour cost and price inflation also depends on more slow-moving, structural trends in the economy which are outside the realm of monetary policy, such as the degree of firm market power and the degree of trade openness.
Authors’ note: The views expressed are of the authors and do not necessarily reflect those of the ECB.
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