What is the wage-price spiral?
The wage-price spiral is a phenomenon where, in an inflationary environment, rising wages lead to rising prices, which in turn leads to demands for higher wages, and the cycle continues. It is also known as « cost-push inflation. »
The phenomenon usually occurs when the labor market faces a shortage of workers, forcing employers to raise wages to attract and/or potentially retain them. When wages rise, the cost of producing goods and services increases, leading to higher consumer prices. As prices rise, workers demand higher wages to maintain their purchasing power, which then leads to further increases in production costs and prices.
The wage-price spiral can be difficult to break because each side of the cycle reinforces the other, resulting in a « vicious circle » of inflation. Today, the goal is to prevent such a spiral from occurring or to « break » it if it does occur. This can be a particularly delicate exercise, as preserving purchasing power requires adjusting incomes without triggering this vicious circle.
Strategies that are often deployed but sometimes insufficient
Central banks aim to ensure a certain degree of price stability over time. In this context, they are vigilant about the formation of wage-price spirals and have several tools/means at their disposal.
- Raising interest rates
By raising interest rates, central banks reduce demand for credit, contributing to a slowdown in economic activity. This can help cool inflationary pressures by making access to financing more expensive, which reduces spending and demand for goods and services.
However, this may not be enough to address the complex and multifaceted underlying causes of the wage-price spiral.
A more comprehensive approach that takes into account the underlying structural factors of inflation is often necessary to effectively address this phenomenon. If the spiral is due to structural factors such as labor shortages or low productivity, simply raising interest rates may not be enough to solve these problems.
Furthermore, raising interest rates can also have negative consequences for the economy, particularly if rate hikes are too aggressive or implemented too quickly. Higher interest rates can increase borrowing costs for businesses, which can reduce productive investment and place too much strain on economic activity. It can also lead to higher unemployment, as businesses may reduce hiring or lay off workers to offset the increase in borrowing costs.
- Adjusting the money supply
The money supply refers to the total amount of money in circulation in an economy at a given point in time and is the key measure used by central banks to assess economic growth and make monetary policy decisions that affect the level of inflation. Other examples of ways to reduce the money supply include:
- Raising interest rates: The central bank can raise interest rates to reduce demand for credit, which can reduce the money supply. Higher interest rates can also encourage individuals and businesses to save more, which can reduce the amount of money in circulation.
- Sale of government bonds: The central bank can sell securities (such as government bonds) to banks and other financial institutions, which can reduce the amount of liquidity available. This can reduce the money supply and help raise interest rates, which can help control inflation.
- Increasing reserve requirements: The central bank can require banks to hold a larger proportion of their deposits as reserves, which can limit their ability to lend and create new money. This can reduce the money supply and help control inflation.
- Balance sheet reduction: The central bank may decide not to refinance, partially or totally, the credit lines granted to banks or to slow down or even end its securities purchase programs (as is currently the case with quantitative easing).
There are several reasons why adjusting the money supply may not be enough to counteract the wage-price spiral:
Time lags: Like fiscal policy, the effects of monetary policy measures can take time to materialize, and the effects may not be felt until well after the wage-price spiral has taken hold.
Structural factors: The wage-price spiral may be fueled by underlying structural factors, such as labor shortages or low productivity, which cannot be fully addressed by monetary policy measures alone.
External factors: External factors such as changes in global commodity prices, exchange rates, or trade policies can also affect inflationary pressures, and these factors may be beyond the control of monetary policy.
Negative side effects: Adjusting the money supply can have negative side effects on the economy, such as reduced investment and slower economic growth. These side effects can exacerbate the underlying structural problems that cause the wage-price spiral.
- The use of fiscal policy
Government spending and fiscal policies can influence economic growth and inflation. In response to inflationary pressures, the government can raise taxes or cut spending to reduce demand in the economy and slow inflation. It can also adopt stop-and-go policies, where, for example, it alternates between periods of expansionary spending and restrictive spending in response to changing economic conditions. It may also increase spending on infrastructure or other public goods to stimulate economic growth and employment, which may reduce inflationary pressures in certain circumstances. More specifically, the government could choose from the following actions, noting that their effectiveness depends on the degree of development of the country concerned:
- Freezing prices of subsidized goods: By freezing the prices of subsidized goods, the government can prevent price increases and keep essential goods affordable for consumers. This can help control inflation by preventing price increases from spreading to other sectors of the economy.
- Freezing public sector wage increases and recruitment: By freezing wage increases in the public sector, the government can limit the growth of public spending and reduce demand for goods and services, thereby putting downward pressure on inflation. By limiting the number of new hires in the public sector, the government also limits the growth of public spending.
- Reducing VAT on essential goods: By reducing value-added tax (VAT) on essential goods, the government can make essential goods more affordable for consumers. This can help control inflation by preventing price increases from spreading to other sectors of the economy.
- Release of strategic stockpiles of raw materials: By releasing strategic stockpiles of raw materials, the government can increase the supply of essential goods and prevent shortages that could lead to price increases. This can help control inflation by preventing price increases from spreading to other sectors of the economy.
However, there are several reasons why fiscal policy alone may not be enough to counteract the wage-price spiral:
Time lags: The impact of fiscal policy on the economy can take time to materialize, and the effects may not be felt until well after the wage-price spiral has taken hold. By the time fiscal policy measures take effect, it may be too late to prevent the spiral from continuing.
Crowding out: Fiscal policy measures that increase public spending can crowd out private investment, which can slow economic growth and exacerbate inflationary pressures.
Political constraints: Fiscal policy measures are subject to political constraints, and there may be resistance to implementing policies that are considered unpopular and/or overly interventionist.
Structural factors: As with monetary policy, the wage-price spiral may be fueled by underlying structural factors, such as skills shortages or low productivity, which cannot be fully addressed by fiscal policy measures alone.
How can wages be increased without triggering a wage-price spiral?
Raising wages without triggering a wage-price spiral can be a delicate balancing act, but several strategies can be used to achieve this goal:
1. Create a productivity shock: By increasing productivity, companies can afford to pay higher wages without increasing production costs, which can lead to higher prices. This can be achieved, for example, by investing in digital transformation and technology, improving processes, and providing training and development opportunities for employees.
2. Controlling costs: Companies can also control costs to help absorb the cost of higher wages without raising prices. This may involve renegotiating contracts with suppliers, reducing overhead costs, and improving inventory management.
3. Implement performance-based compensation: Rather than increasing wages across the board, companies can implement performance-based compensation systems that reward employees who meet or exceed specific goals. This can help motivate employees to increase productivity and reduce the risk of a wage-price spiral.
4. Consider non-monetary benefits: In addition to salary increases, companies can offer non-monetary benefits to attract and retain employees. These can include flexible working arrangements, additional vacation time, or other benefits that improve work-life balance.
5. Monitor inflationary pressures: Finally, companies should monitor inflationary pressures and adjust wages accordingly. This may involve conducting regular market research to ensure that wages remain competitive, and adjusting wages in line with inflation rates to maintain employees’ purchasing power.
By adopting these strategies, and with the support of policymakers, companies can increase wages without triggering a wage-price spiral, which can help attract and retain talented employees and improve bottom-line results.
Appendix: Use case from the 1970s in France
Like other countries, France has experienced wage-price spirals in the past. A notable example occurred in the 1970s and early 1980s, when the French economy was experiencing high inflation of over 13%.
During this period, following an oil shock, French workers demanded higher wages to keep pace with rising prices, which led to further inflationary pressures. In response, the French government implemented policies to try to control inflation:
- Price controls: The government imposed price controls on a range of goods and services, including food, energy, and transportation.
- Wage controls: The government introduced wage controls that limited wage increases for workers in both the private and public sectors. This helped to limit the rise in labor costs, which had been another key factor in inflation.
- Currency devaluation: The franc was devalued to make French exports more competitive in international markets.
- Austerity measures: The government implemented austerity measures, including spending cuts and tax increases, to reduce the budget deficit and stabilize the economy.
- Monetary policy: The French central bank tightened its monetary policy by raising interest rates and reducing money supply growth.
However, these policies have often proved ineffective in breaking the wage-price spiral, and in some cases have even exacerbated the problem. For example, wage controls have led to lower productivity and industrial unrest, while price controls have caused shortages of certain goods and services.
Since then, France has implemented various policies to try to prevent the wage-price spiral from occurring. For example, the government has put in place mechanisms to link wage increases in the public sector to productivity gains rather than inflation, and has created independent institutions, such as the Pension Advisory Council and the High Council for Financial Stability, to monitor and regulate economic trends. A process was also initiated to make the Bank of France independent (which it became in 1994).
However, despite these efforts, France, like other economies, is still susceptible to wage-price spirals when there is a labor shortage or other factors that lead to inflationary pressures. Therefore, constant vigilance and policy adjustments are necessary to prevent or mitigate the impact of such spirals.
[1]Among these causes are: imbalances in bargaining power between workers and employers, technological changes (such as automation, which changes the requirements in terms of workforce profiles), lack of investment in education, training, and skills development (leading to a mismatch between labor supply and demand), discrimination in hiring and compensation practices (which can lead to wage disparities and lower wages for certain groups of individuals), and a rigid labor law framework, etc.
[2]The crowding-out effect refers to the phenomenon whereby an increase in public spending or borrowing leads to a decrease in private sector spending or borrowing. Public borrowing increases the demand for credit, which can lead to higher interest rates and a decrease in the credit available to private borrowers. This mechanism is more common in emerging economies.
