Should we be worried about a wage-price spiral? Well, yes, but maybe not in the UK
Last Thursday, the Bank of England’s Monetary Policy Committee responded to rising inflation by raising the bank rate to 0.5%. In its Monetary Policy Report, it says (among other things), that “Underlying earnings growth is estimated to have remained above pre‑pandemic rates, and is expected to strengthen over the coming year.” Much has been made about the looming risk of a potential wage-price spiral—in which higher wages could become both the cause and the consequence of higher inflation.
What is intriguing about this debate is the degree to which commentators are focusing on UK wages. In some ways that makes sense: rising prices for UK consumers could mean rising wage demands from UK workers. But in another way, I’m not convinced such a focus is consistent with the big picture. The prices of goods, in particular, are set in global markets. To date, the vast majority of inflation has been imported. So, if anything, wage-price spirals in other countries is what we should be worried about.
[Of course, the Bank of England has no direct influence over inflation in other countries or global markets. But that is what it is having to counteract right now. Raising interest rates does help, by supporting the UK currency — which, until the picture changes and inflation becomes more rooted in domestic services, is going to be one of the biggest influences on the level of inflation we experience.]
So how important are UK wages in driving inflation, then? I do not have a model to predict the future, but we can certainly look at past events. In the chart above, I’ve categorised each of the 220 items that make up the Consumer Price Index (CPI) based on the labour intensity of their production, and shown the contribution each category made to annual price inflation. For labour intensity, I’ve used a fairly crude measure: total labour compensation divided by gross output, in dollars, in 2018, across OECD countries.*
Two things stand out: first, the largest contribution to inflation in December 2021 came from very low-labour-intensity sectors (dark blue segment of the last column on the right). No surprise there: both energy and food, which were among the items with the highest price rises, and also have significant weighting in the CPI basket, were big drivers of inflation in December. Neither the energy nor food manufacturing sector employ a lot of people, relative to their output. Prices in those markets are more likely to go up for non-wage-related reasons.
Perhaps more interestingly, there were also a few fairly labour intesive items that contributed to inflation a lot, giving us a bit of a bi-modal distribution. If you were to double-click on the orange “2nd quintile” segment of the right hand column, here are some of the items you would find: clothing, furniture, and hotels and restaurants. Of these, both clothing and furniture are also frequently imported, indicating that the price of these items might be more driven by global markets and exchange rates than they are by domestic wages.
But, to be on the safe side, we should watch out for signs of endemic, domestic wage-price spirals. This analysis does suggest items to watch out for in the future. If the shape of inflation changes such that a larger contribution comes from domestic, labour-intensive sectors, then UK wages would start to have larger consequences for overall inflation. The items that fall into that category, in addition to the restaurants and hotels mentioned above, include education and health, and some transport and construction services.
None of the above is intended to override the much more sophisticated modelling that many economists undertake to understand the linkages between different sectors and how higher output prices from one sector feed into higher costs for other sectors, and eventually higher prices for consumers. Most importantly, by looking at end-user consumption, and linking it to the production of the goods and services in question, I’m ignoring the important role that many intermediaries — such as wholesalers and retailers, or storage and transport toperatives — play in supply chains. Those intermediaries are fairly labour intensive and domestic, and, were overall wages to keep rising, will undoubtedly look to recover some of the increased cost in their prices.
[* A better analysis would be to do some kind of weighted average based on where the UK imports stuff from. Alternatively, I could have just used UK labour intensity figures. I did do an alternative version, using UK data and measuring labour intensity as employees per £1,000 of turnover; the overall results look very similar, with a slightly bigger share of inflation coming from both bottom- and top-quintile sectors by labour intensity — in other words, an even more bi-modal distribution.]
