Are There Real Fears of a Low Unemployment Wage-Price Spiral or Is the Bank of
Canada Trying to Kill a Dead Horse?
Mario Seccareccia
University of Ottawa
Monetary Policy Institute Blog #84
“In a world in which rentiers have been trying to re-establish and preserve their share, just as workers have been, with only very limited success, why do central bankers not just as easily consider the existing interest-rate dynamics as fueling a “rentier price spiral” since 2022 and worry about the consequence of the latter?”
Here We Go Again with Yet Another Rate Hike to Combat Inflation!
On June 7th, the Bank of Canada (BoC) raised its benchmark overnight rate by another 25 basis points to 4.75 percent from its last official rate hike last January. In its assessment of the first quarter of 2023, the Bank highlighted that economic growth was 3.1 percent, which was significantly higher than the last forecasted 2.5 percent real GDP growth. Inferring from this above-expected growth pattern, the BoC concluded that “excess demand in the economy looks to be more persistent than anticipated.” Given the economy’s continued resilience with a Canadian output growth of over 3 percent and a supposedly stubborn low unemployment rate hoovering at around 5 percent average over the last five months of this year, which is seen as being dangerously below some nebulous “natural” unemployment rate consistent with a steady inflation rate of 2 percent, the Bank’s press release informed Canadians of the verdict: the “Governing Council decided to increase the policy interest rate, reflecting our view that monetary policy was not sufficiently restrictive to bring supply and demand back into balance and return inflation sustainably to the 2% target.”
Recognizing that Canada’s real GDP growth exceeded by a mere 0.6 percentage point more than expected during the first quarter of 2023 (that is, during a three-month period this year when the inflation rate significantly declined and the official unemployment rate remained low and stable), wouldn’t one want to celebrate this seemingly positive macroeconomic achievement of sustained growth and declining inflation, particularly since the Canadian economy has struggled so hard to come out of a prolonged overhanging pandemic environment over the last few years? The answer, of course, is “no”! To punish the Canadian economy for its relative macroeconomic success, the Bank openly wants to abort this macroeconomic growth. The BoC fears an acceleration of inflation that would supposedly be associated with this obstinately high growth and low unemployment state even though the evidence of a Phillips curve is not there (on the latter, see here).
Therefore, despite a significant decelerating inflation rate during the first quarter of 2023 that went from 5.9 percent in January to 4.3 percent in March and then stalling at 4.4 percent inflation in April, from the visible action of the Governor and his Governing Council, the Bank feels that only a recessionary environment might actually save Canada and prevent the inflation rate from getting “stuck materially above the 2% target” because of these supposedly tight labour-market pressures.
However, there may well be dangers associated with this overzealous interest-rate policy action that tries to combat what is primarily a supply-side inflation due to forces beyond domestic demand pressures. Ever since the time of the so-called Volcker shocks of the late 1970s and early 1980s, it is well-known that the economy responds non-linearly via discontinuous jumps, whereby a whole series of interest-rate rate hikes may have little impact on economic growth, but one minor additional increase may well be the coup de grâce eventually tipping the economy into a serious recession. Can this last proverbial straw of 0.25 percent break the camel’s back? Why risk a recession just to get the inflation rate more quickly down by less than 1.5 percentage points in the hope that it will supposedly return the inflation rate within the BoC target range of one to three percent by the end of 2023? Since the Bank’s “credibility” is at stake if it were to abandon its 2 percent inflation target, it seems to be quite overtly maneuvering to push the Canadian economy into recession despite the fact that the inertial inflation rate in Canada persists above target primarily because of out-of-control international inflationary pressures. To achieve its goal, the Bank must rely on the fear that domestic inflation is unsustainable because of supposed excessive labour market tightness that can spiral upward both wages and prices domestically, thereby completely de-anchoring inflationary expectations. If the inflation is perceived as spiraling “out of control”, then given its mandate the Bank is justified to prevent the latter.
The “Wage-Price Spiral” Boogeyman: An Historical/Explanatory Note
At a conference session sponsored by the Centre for the Study of Living Standards and the Progressive Economics Forum in Winnipeg, Canada, on Saturday, June 3rd, held at the annual meetings of the Canadian Economics Association, a debate took place over this very question of the existence of a wage-price spiral. Well into the COVID-19 pandemic and until the latter half of 2021, few actually believed that the accelerating inflation would be more than a temporary blip arising from supply-chain problems and the possible unintended de-globalization consequences resulting from recurrent lockdowns internationally until early in 2022. In Canada, although the bank rate had been very mildly rising until 2019, on March 27, 2020 the Bank of Canada slashed the overnight rate to its lowest level (i.e., the interest rate on positive settlement balances) down to 0.25 percent and pegged that rate until the beginning of March 2022, while simultaneously launching officially its asset-purchase program of QE that also lasted two years until March 2022, when it reversed gear and initiated QT.
At the beginning of 2022, the discourse among policymakers changed dramatically as the monetary authorities began to fear a “wage-price” spiral that, supposedly, might ensue from the accelerating inflation. Almost unprecedented historically, central bankers actually began overtly to beg workers to respond to the inflation “shock” by not demanding significant wage increases, especially as the inflation got a further boost in late February because of the war in Ukraine. For instance, already in early February 2022, Governor Andrew Baily of the Bank of England appealed to British workers to refrain from asking for inflation-matching pay rises, and he warned that there was a risk of inflation getting “out of control” and becoming “embedded”. Jerome Powell and Tiff Macklem came out with similar appeals for “wage moderation” fearing a “wage-price spiral”, as this perception was further reinforced by a series of tweets at the end of December 2022 by Olivier Blanchard warning about the danger of a potential wage-price spiral (for a discussion of the controversy, see here).
But has there actually been a wage-price spiral justifying the recent harsh central bank actions that have persisted since March 2022 in raising interest rates to levels not seen in over two decades and what exactly is this “wage-price spiral” Boogeyman?
Theoretical discussions over the concept of a “wage-price spiral” have a very long history. Although even before WWII a celebrated heterodox economist, Joan Robinson, in her Essays on the Theory of Employment in 1937 alluded to the risk of prices spiraling at full employment (see here), it was Franklyn D. Holzman (1950) who was one of the earliest to theorize about a wage-price spiral under conditions of either full employment (FE) or, at less than FE, within a sectoral supply-constrained environment after WWII (the latter environment perhaps being somewhat analogous to the situation of supply bottlenecks faced since the 2021 economic recovery from the pandemic). All this, of course, was much before Milton Friedman reframed the process within a questionable monetarist logic of the accelerationist hypothesis.
According to Holzman’s heterodox conflicting claims model of inflation, a “wage-profit-price spiral” is “an example of the inflationary pressures generated by changes in the distribution of income between and within all economic groups.” (Holzman 1950, p. 152) For example, let us take a brief look at the “between group” distribution giving rise to a class conflict inflation. Once there is an inflationary shock to the system that affects one group at the expense of another, let us say in a fully-employed economy, where aggregate income is defined as follows:
that is, where P is prices at time period t, Q* is full-employment output, W is the total wage bill, Π is the flow of business profits and R is interest or rentier income. The response, say, by workers to the shock that, for instance, first raises P and Π and which then can potentially generate a wage-price spiral since the ex-ante income claims W/Y + Π/Y + R/Y >1 generates a situation that cannot be validated without a further wage/price increase until the excess of claims over output is eliminated.
To understand this further, let us assume that there is a “shock” that raises either wages and the wage share W/Y or the profits share Π/Y, as it occurred in 2020 and 2021 respectively. According to Holzmanian logic, this can then potentially trigger a wage-price spiral. Stipulating some simple linear wage and price-adjustment relations respectively:
where Δw/w is wage growth, ΔP/P is price inflation and OV = other variables, the ΔP/P = β[αΔP/P + OVw] + OVp which says that, given the OVs, the internal dynamics of the inflation, traced by what becomes a solution to a simple difference equation, will depend, ceteris paribus, on whether the compounding effect of the response parameters coincide with αβ < 1, αβ = 1, or αβ > 1.
However, the asymmetry of the bargaining power reflected in a group’s ability to respond quickly is critical. Within a conflicting claims model, as pointed out by Blanchard in 1986, if the speed of adjustment of one group prevents it from fully recovering its loss systematically (because of delayed wage-price adjustment resulting from the existence of long-term contracts), then the spiral would not be an explosive one, that is that definitely αβ < 1. This means that the inflation rate will eventually converge back to some stable environment as may have existed before the shock.
Conversely, if we are dealing with a situation where the power of each group to effectuate changes is more evenly balanced, then once the ex-ante income claims W/Y + Π/Y + R/Y > 1, this system can easily generate an expansion of wages and prices either by achieving a new steady-state path of inflation after the initial shock (i.e., when αβ = 1) or it can become explosive (when αβ > 1).
While these possibilities have been very much considered by economists historically, the vocabulary that currently prevails among central bankers is extremely imprecise, since, strictly speaking, the case of a situation of αβ < 1 ought not to be characterized a “wage-price spiral” if, for instance, the system can potentially converge back without the forceful actions of governments and central banks. In fact, the recent environment since 2021 has been one in which wages have fallen short of fully “catching-up” with prices, especially in the unionized sector because of lengthy staggering contracts as evidenced by the recent federal public sector strike in Canada. It is only over the last while that workers have been struggling to catch up, especially in those sectors such as health care, tourism, restaurants and the broad hospitality industry where problems of employee retention have become chronic after the removal of the restrictive lockdowns in 2021.
In addition to this inaccuracy of the vocabulary, there are other problems with virtually all of those research studies going back to WWII (including Blanchard’s work). For instance, all these models have focused exclusively on the dynamics between W/Y and Π/Y and merely take R/Y to be a completely passive value that is determined residually.
That is not completely so, especially with the emergence of inflation targeting (IT) regimes, in which central banks have become instruments to protect or raise rentier incomes! Hence, central banks can become the instrument to support one group at the expense of another. Through central bank actions, interest rates can also play an “active” role of raising (and not just reducing) inflation while seeking to preserve the rentier claim. Here is a mere quote from Statistics Canada on last April’s CPI increase of 4.4% by highlighting the strategic importance of the mortgage and housing cost elements pressuring upward the overall CPI, which would suggest the extent to which central banks may be chasing their own tails in their inflation fighting in the context of staggered mortgage-rate adjustments:
“Shelter costs rose 4.9% on a year-over-year basis in April, after a 5.4% increase in March. Canadians continued to pay more in mortgage interest cost in April (+28.5%) compared with April 2022, as more mortgages were initiated or renewed at higher interest rates. The higher interest rate environment may also be contributing to rising rents in April 2023 (+6.1%) by stimulating higher rental demand.”
In a world in which rentiers have been trying to re-establish and preserve their share, just as workers have been, with only very limited success, why do central bankers not just as easily consider the existing interest-rate dynamics as fueling a “rentier price spiral” since 2022 and worry about the consequence of the latter? In reality, the contemporary environment of both wages and rentiers barely trying to catch up can be considered neither a wage-price spiral nor a rentier-price spiral. As to a “profit mark-up spiral”, as we have seen from other important articles on this blog, it remains a much-debated issue among heterodox economists, even though firms’ ability to preserve their desired mark-ups is hardly debatable and may well have been a significant factor in the last two years of inflation once these shocks to the domestic economy occurred.
What Are Some of the Facts?
Let us first quickly look at some indication of what happened to the labour share (the ex-post W/Y). I have traced the index of quarterly time series beginning in 1990 (with 2012=100), which displays what is already well known of its downward historical tendency until the Great Financial Crisis (GFC) of 2007- 2009 and then fluctuated more or less around a constant trend until the COVID-19 crisis. During the pandemic, there was an initial expansion of the share of labour that reached a level not seen since the early 1990s. But it was extremely short lived, since after peaking during the second quarter of 2020, by the end of 2020 it quickly collapsed to the level reached before the pandemic at the end of 2019. Moreover, it is clear that, with the exception of the long decline of the share from the early 1990s to the GFC, the series followed a stationary path with the jumps arising every time there was an official recession in Canada.
Observations, 1990Q1–2023Q1 SOURCE: Statistics Canada
Indeed, as is discernible from Figure 1, every time there was a recession, we witnessed a significant rise in the share of labour. This is for at least three reasons: (1) business firms tend to retain the more highly skilled workers (including what Michał Kalecki referred to as overhead labour) even as production falls; and (2) particularly large business enterprises tend to lay off workers at the bottom of the wage scale, usually in accordance with firm-specific seniority districts. These two phenomena alone would explain why the average wage rose so quickly even though individual wage rates themselves rose little. In addition, (3) given the sector lockdowns, particularity of the industries most affected at the beginning of the pandemic, certain manufacturing and low-wage consumer services were impacted even more so than high-income services by these lockdown measures, such as financial services and the public services (including education and health-care services), where employees were retained and/or shifted to telework.
Hence, the huge jump in the share of labour reflects primarily this strong compositional effect, with the share falling once the economy began to recover by late 2020 and early 2021. But why did it continue to fall throughout 2021 until the third quarter of 2022 long after the lockdowns ended and workers had been rehired? That continued sharp decline had to do primarily with the fact that wages were not at all catching-up with price increases because of the weakened position of labour until the second half of 2022; and it was only by the end of 2022 and during the first quarter of 2023 that Canada’s labour share had returned to the level that had been reached before the pandemic in 2018 and 2019.
Anticipating this wage catch-up, the central bank became obsessed with this prospect of unhinged inflationary expectations and the potential of a wage-price spiral as strong pent-up demand stimulated growth and brought unemployment to historically low levels. Despite this recovery, a wage-price spiral did not materialize since, even as wages did seek to catch up, wages only grew slowly. Moreover, price inflation first rose but then eventually slowed down in the second half of 2022, which would suggest a αβ < 1. This can be further observed from the series in Figure 2 when dissecting the share of labour in terms of its real wage (deflated by the GDP deflator) and productivity growth patterns. Hence, despite the chaotic situation during the pandemic, wage cost to firms (the blue line) only just began to surpass average labour productivity growth (the red line) since the latter half of 2022 as productivity growth began to plummet again.
Firms), Canada, Quarterly Observations, 1990Q1–2023Q1 SOURCE: Statistics Canada
There is clearly no evidence of a wage-price spiral in Canada over the last while. Historical records internationally also support this conclusion that the fears of a wage-price spiral are generally unfounded. In a study by Alvarez, et al. at the IMF in November 2022, when studying 79 similar historical inflationary records, they found that these initial inflationary shocks were on average followed by an increase in wage growth, but without ending in a wage-price spiral so that generally αβ <1. They affirm that: “Of the 79 episodes identified with accelerating prices and wages going back to the 1960s, only a minority of them saw further acceleration after eight quarters. Moreover, sustained wage-price acceleration is even harder to find when looking at episodes similar to today, where real wages have significantly fallen.” Alvarez, Bluedorn, Hansen, Huang, Pugacheva, & Sollaci (2022, p. 18).
Perhaps, more importantly, one ought only to look at a recent US study authored by none others than Ben Bernanke and Olivier Blanchard for the Hutchins Center at the Brookings Institution in May 2023. Although still hopelessly trying to resuscitate the Phillips Curve by using a less conventional unemployment/vacancy variable and unconventional catch-up variable, they also concluded that there was no evidence of a wage-price spiral in the US. They write:
“Although the Phillips curve was operative, inflation expectations did not de-anchor and there was little evidence of a wage-price spiral, in that workers did not achieve nominal wage gains sufficient to compensate them for unexpected price increases (a weak catch-up effect). Our decomposition of inflation shows that tight labor markets alone made only a modest contribution to inflation early on.” (Bernanke & Blanchard, 2023, p. 38)
Although no longer alluding directly to the dangers of wage-price spiral, we are told by the BoC nowadays that there is overwhelming evidence of demand pressures that can potentially lead to what could otherwise be an explosive outcome. For instance, speaking just a day after the Bank’s announcement in defense of the Governing Council’s decision, Deputy Governor Paul Beaudry states:
“This decision [on raising Canada’s overnight rate] was based on an accumulation of evidence that points to excess demand in the economy persisting longer than expected, increasing the risk that inflation could get stuck above the 2% target.” (Beaudry, 2023)
But what and where exactly is this “accumulation of evidence”? Instead of being evidence-based, all that one can seriously infer from the Bank’s decision is an “eminence-based” interpretation that a 5 percent unemployment rate is too low relative to some presumed “natural” unemployment rate for Canada that would be consistent with a 2 percent steady-state inflation rate. In a world economy in turmoil, with the drivers of inflation being mostly determined outside of Canada, including the deepening climate crises impacting on world food supplies, one cannot but agree with analysts, such as Frances Donald of Manulife Investment Management, that the BoC has been unfairly given too narrow a task of bringing the inflation rate down to 2 percent with the use of a single blunt instrument that can lead to dire consequences for the Canadian economy over the coming months unless offset again by yet another round of fiscal stimulus.
In the current political climate of threats from Canada’s Conservative Party, the chances of fiscal expansion to offset a BoC-induced recession would be extremely remote.
