Rodney's Ravings: The wage-price spiral means we’re in for a more painful inflation battle

Guest post by Rodney Dickens

For anyone old enough to remember the 1980s, the term “wage-price spiral” should ring a bell.

It’s a situation in which pay and price increases fuel one another, in an environment where inflation has been boosted by overly-stimulatory government and central bank policies.

This is exactly what happened in lots of countries around the world in response to Covid – and actually, in NZ’s case, even prior to it. These policies created excessive demand for goods and services, driving up prices and also fuelling higher pay increases for workers.

Central banks have now tightened policies dramatically to rein in the inflation problem they helped to create, but the battle will be drawn out

And that's because wage-price spirals have developed in many countries.

The charts below illustrate the issue in NZ and the US, comparing consumer price index (CPI) inflation with hourly earnings inflation – but it’s a similar story in many countries.

The US has richer availability of data, so the first chart uses a measure of "core CPI" inflation that excludes volatile energy and food costs.

In New Zealand, while CPI inflation is falling, helped by a lower oil price, core inflation (excluding energy and food costs) isn’t.

What the charts show is that price and wage inflation in the two countries is at the highest levels we’ve seen since the 1980s. There have been milder inflation episodes in NZ since the 1980s, all of which have resulted in at least mild recessions, with the Reserve Bank hiking interest rates to battle inflation.

There’s yet to be an instance where the economy has achieved a “soft landing” after inflation has been allowed to gain the sort of foothold it has now.

That’s because once price and wage inflation reach the levels we’ve seen recently, inflation gains a life of its own thanks to the wage-price spiral.

With the unemployment rate still low, workers have the bargaining power to negotiate higher pay increases and offset increases in the cost of living, while most firms faced with larger cost increases (including wages) can pass them on via larger price increases. And so the cycle goes.

In order to break wage-price spirals, central banks have to hike interest rates until they undermine workers’ bargaining power and businesses’ ability to pass on cost increases.

Theoretically, this could be achieved by central banks increasing interest rates enough – and keeping them at the right level – to achieve a protracted period of below-average economic growth. Gradually this would boost the unemployment rate, and undermine firms’ ability to pass on cost increases i.e. a “soft landing”.

However, central banks tend to operate monetary policy more like a sledgehammer than a scalpel

In the past, when faced with wage-price spirals, they always tighten too much and for too long – while (at the other end) they were too slow to start hiking in response to the inflation problem that was already starting to emerge in NZ before Covid.

To illustrate, we just need to look at the milder inflation problem we had in the 2000s – which culminated in a reasonably severe recession, made worse by the GFC. NZ’s recession had started before the GFC because of a major increase in interest rates as the Reserve Bank battled inflation.

The current inflation problem is worse than what we had then, meaning that either a more severe recession or a series of milder recessions will be required to break the wage-price spiral. In the case of the worse inflation problem in the 1980s, a series of mild recessions over a five-year period was needed to break the wage-price spiral.

Unfortunately, economists and commentators who are suggesting that a soft landing is possible are relying on wishful thinking, rather than analysis of historical experience, and without allowance for the reactive decision-making by central banks.

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