The Wage-Price Spiral

In light of the high inflationary environment prevailing since the beginning of 2022, the threat of a wage-price spiral has emerged. Many economists are concerned about the economic consequences and causes of such an event, which has already occurred several times in history.

The wage-price spiral, also known as the inflationary spiral, is a theory that shows the correlation between an increase in salaries and an increase in the price of goods. In the realm of macroeconomics, it is a widely utilized hypothesis. This depicts a loop in which rising salaries and prices put upward pressure on the economy, resulting in inflation; raising salaries has several implications, including raising the cost of goods, improving consumer spending power, and increasing commodity demand.

Explaining the effect

When workers notice a rise in the rate of inflation, they can expect a rise in the cost of living. Therefore, they will request salary increases above the current inflation rate to maintain their current income. Businesses' costs will rise, resulting in higher consumer goods prices, driving inflation higher. As nominal income and purchasing power rise, workers will increase their consumption expenditures, resulting in demand-driven inflation.

As inflation continues to rise, workers will expect higher and higher inflation rates and therefore will negotiate larger and larger pay raises. The spiral effect is evident.

The following are some of the elements that contribute to a wage-price spiral:

• Trade unions, which play a significant influence in raising real wages.
• Strong economic growth, which creates demand-pull factors that push prices higher.
• Low unemployment, which makes it difficult for businesses to fill job openings, providing workers more negotiating power.

One of the most popular illustrations of this effect is the oil crisis in the United States in the 1970s. At that time, high OPEC oil prices led to a generalized wage-price spiral in the economy.

1970s: OPEC oil crisis

Growing costs prompted unions to seek higher pay, creating the wage-price spiral. This resulted in widespread inflation, as depicted in this graph, with corporations having raised their prices to match higher wages in the United States, which saw a 7-10% increase in labor expenses every year during the 1970s.

As a result, the Federal Reserve intervened and raised interest rates to limit the availability of money in the markets and keep inflation in line. Unfortunately, despite successfully stopping the spiral, it did so at the expense of the economy, resulting in a deep recession in the early 1980s.

During the same period, a large wage-price spiral was witnessed in the United Kingdom, which was primarily caused by inflation due to these rising oil costs and the considerable bargaining power of unions at the time – their reach allowed them to demand higher wages, which further fueled inflation in the country.

Measures to be undertaken

By definition, inflation increases when demand exceeds supply. With increased production, supply equals demand, keeping prices in check. And when inflation expectations fall, the demand for higher wages also falls, breaking the spiral.

Second, governments use central banks to control inflation – central banks intervene by altering interest rates and using monetary policies to manage the money supply. Higher interest rates deter people from spending. As a result, demand falls, and prices fall. Lower prices stabilize wages, putting a halt to the downward spiral.

Many countries use inflation targeting to keep inflation under control – inflation targeting is a monetary policy tool in which the central bank sets an inflation target rate and makes adjustments to reach and maintain that rate over time.

An effect that may be repeating itself

Many indicators suggest that the American economy is on the approach of a wage-price cycle, with inflation and wages rising at their greatest rates in decades: In 2022, consumer prices and salaries began to rise at rates of 7.5% and 5.7%, respectively, compared to the previous year, levels not seen since the 1970s.

The case for a lengthy period of high inflation appears to be evident. It is worth noting that the pandemic's supply disruptions and the recent supply shock to energy prices caused by the Ukraine war are reminiscent of the 1970s oil shocks. Second, monetary policy was very accommodative in the run-up to these shocks, as it is today.

In the United Kingdom, a similar situation has lately developed, with certain indicators pointing to a wage-price spiral. In Spring 2022, inflation is expected to reach 8%, and unemployment will stand at an all-time low.

Eventually, after several months of above-target inflation in the major advanced countries, a more aggressive than expected tightening of monetary policy may be required to bring inflation back to target, which could precipitate a major decline similar to that seen in the early 1980s.

There are grounds, however, to be skeptical. Wages and prices should be kept in check as productivity increases, unions weaken, and inflation expectations decline.