Wage Inflation Spiral: Playing with Fire

A wage inflation spiral follows a simple logic. Seeing prices go up, consumers ask for higher wages, and that feeds higher consumer prices. Up to that point, everything is fine and dandy. But if consumers see inflation persevere, they start to expect it and also expect wage increases to compensate for it. That’s when a spiral sets in.

“Inflation expectations are just as important as the actual inflation rate itself, asserts Anil Passi, Director, global corporates, at DBRS Morningstar. Expectations change behaviour, including the cancellation of purchase decisions and demand for higher wages. This is what central banks have to wrestle with: not just the consumer price index (CPI), but how they can affect the psychology of people.”

Employers Are Increasing Worker Wages

In the meantime, inflation is pushing ahead, and not only are wage increase demands multiplying, but substantial wage increases are also being implemented. An emblematic one is Apple’s, which has given a 10% hike to its retail workers in the U.S. and raised its companywide compensation budget. “Apple is a very attractive employer, Passi highlights. People want to work for Apple. It gives a 10% increase.”

Many other major names have also handed substantial increases: Google, Walmart, Chipotle and Microsoft in the U.S., RBC, Starbucks and TD Bank in Canada. An unsettling feature of these pay raises, is that “they are happening on an unusual schedule,” notes Derek Holt, Vice-president and Head of capital markets economics at Scotia Bank. They don’t necessarily happen according to a set yearly schedule of wage renegotiations, but pop up in response to exceptional job market pressures.

As inflation increases, higher wage demands are accelerating. In Canada, Passi notes, average weekly earnings for March were 4.3% higher than the previous year, and nearly two percentage points above the mark of 2.4% the previous month.

Such numbers indicate that Canada is catching up to the situation in the U.S. “The job market in Canada is very similar to the one in the U.S., except that it usually shows a six-month lag,” says Yanick Desnoyers, Vice-president of economics at Addenda Capital. For their part, our Southern neighbours have seen average wage increases of 5% year-over-year and month-over-month, Holt points out. However, there is a positive note: for the last three months, U.S. numbers show no wage growth. “Is it only a temporary pause? Holt asks. Will the rise resume? We don’t really know yet.”

Other Factors That Impact Wages

The evolution of labour productivity is a key factor that troubles Holt. “It keeps falling in Canada, that is something that worries me, he says. Even if you don’t get big wage gains, if productivity falls, that’s still inflationary.”

Another element potentially feeding a wage inflation spiral, says Desnoyers, is the speed at which unemployment has fallen. “We had a drop of ten percentage points in less than 24 months; that’s five times faster than usual. Usually it takes ten years to get such a drop. We haven’t seen that since the war. It increases the fear of a spiral.”

That indicates an exceptional pressure at work in the labour market, which is highlighted by the present acute demand for jobs. As a construction entrepreneur tells us: “There’s a new corporation dominating Canada that we now see everywhere, and it’s called HIRING Inc.” “Central banks haven’t seen that rapid fall in unemployment and responded very late,” comments Desnoyers.

Now, central bankers need to get a hold of inflation before expectations set in. As Desnoyers explains, commodity price increases and supply-chain logjams can cause inflation to shoot up, but they usually are temporary phenomena. If inflation expectations take hold of the wage setting mechanism, that’s another story.

What Will Make Us Reach a Tipping Point?

What would be the tipping point when simple wage increases turn into a wage inflation spiral? Desnoyers says it all rests in central banks’ credibility and to what extent workers believe that central banks will succeed in pulling back inflation. It works a bit like this, Desnoyers illustrates. An employee asks his boss for a 6% raise and his boss answers that inflation will soon come back down to 2% because the central bank will do its job. But then, the employee retorts: I don’t believe it! “That’s when the spiral sets in,” Desnoyers states.

“It’s one of the biggest questions presently,” Holt says, recognizing that “we could be transitioning to that stage.” With all the reports flying in of wage increases, “there may be something going on here, but we need more data” before anything can be asserted with any certainty. Passi is of a similar mindset: “The jury is definitely still out,” he admits.

One thing is certain, “the longer inflation persists, Holt contends, the more people will set their behaviour patterns and expectations on that, and set in wage adjustments accordingly. We’re not at a capitulation point yet where we have to learn to live with inflation for years, but central banks definitely need to stay on course and act decisively, especially this summer.”

What does “act decisively” mean? Presently, Desnoyers indicates, the break even inflation rate on 5-year US bonds is 3%, a rather high number. “It went up to 3.6% on March 27^th, but since came down to 3.1% after the Federal Reserve raised its voice and said that it was ready to go beyond the breakeven point (when rates are neither accommodating nor restrictive), the economist says. “It is good news and markets think that the Fed has finally woken up.”

But watch out: if this breakeven point goes up too much, “it will mean that the Fed is losing credibility”, Desnoyers indicates, who thinks that the Fed, to remain credible and finally tame inflation, will not have the choice but to raise rates at 4.5%, at least 150 basis points above an expected yearly inflation rate of 3%.