## ch2

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### Overview and recent dynamics
- Inflation in 2021 reached levels not seen in almost 40 years in many economies as the recovery picked up after the acute COVID-19 shock.
- Contributing factors to sharp price rises: pandemic-related supply chain disruptions, commodity price shocks, expansive monetary policy and fiscal support, a surge in pent-up consumer demand, and changes in consumer preferences for goods versus services.
- Labor demand resurged while labor supply was slow to respond (workers hesitant to reengage because of ongoing health concerns and difficulties finding child and family care), producing tighter labor markets and increased wage pressures.
- Average nominal wages (per worker) rose and the unemployment rate fell beginning in the second half of 2020 across economy groups; nominal wage growth in 2021 mostly brought the average level back to the pre-pandemic trend but did not fully keep up with price inflation, so real wages were fairly flat or falling.
- Sectoral patterns: nominal wages in both industry and services tended to converge to common pre-pandemic trends; sectoral employment shifts appear to explain little of overall wage changes through end-2021.

### Definition and analytical focus
- Wage-price spiral defined as an episode of several quarters with accelerating wages and prices (both wage and price inflation rates rise simultaneously).
- Central policy question: could recent dynamics evolve into a persistent wage-price spiral driven by changes in inflation expectations and tighter labor markets prompting sustained worker wage demands?
- Key analytical questions:
  - How do post-COVID wage, employment, and price dynamics compare with pre-pandemic dynamics and historical episodes?
  - How well do inflation expectations and labor market conditions explain recent nominal wage growth?
  - Could post-COVID wage and price pressures lead to high and persistent inflation, and how effective is monetary tightening in reducing those pressures?

### Main empirical findings (chapter summary)
- Both wage and price inflation picked up broadly through 2021; real wages tended to be flat or falling on average.
- Historical analogues: on average, wage-price spirals did not follow historical episodes similar to the current circumstances in advanced economies; similar past episodes (with flat or falling real wages) typically saw inflation fall afterward while nominal wages gradually caught up.
- By end-2021, changes in inflation expectations and labor market slack explained wage dynamics relatively well; earlier in the pandemic wage growth was poorly explained by those relationships.
- Structural decomposition (multi-sector, multi-economy model) finds wages in 2020–21 were driven predominantly by production capacity and labor supply shocks (social distancing and lockdowns), while prices were more affected by private saving and release of pent-up demand.
- Expectations formation matters: more backward-looking expectations require monetary policy to be more front-loaded to minimize de-anchoring risks. Observed decline in real wages has so far acted as a drag reducing price pressures and helping inhibit a wage-price spiral.

### Historical episode evidence
- Sample and episodes:
  - Sample comprises 30 advanced economies with quarterly data back to 1960 at the earliest.
  - A sample of advanced economies covering the past 40 years (and for a few the past 60 years) reveals 22 other episodes exhibiting similar conditions to the COVID-19 recovery episode.
  - Annex: Seventy-nine such episodes identified within a sample of 30 advanced economies, the earliest going back to 1960.
- Selection criteria for episodes: at least three out of the previous four quarters had (1) rising inflation, (2) positive nominal wage growth, (3) declining real wages, and (4) declining or flat unemployment.
- Findings:
  - Similar past episodes were not followed by wage-price spirals: nominal wage growth tended to increase somewhat after these episodes, but inflation edged down on average, leading to an increase in real wages; unemployment generally stabilized.
  - Heterogeneity exists; notable outliers include:
    - United States, 1979: inflation rose rapidly for four quarters before declining; unemployment rose more than in other identified episodes; monetary tightening (Volcker disinflation) was decisive.
    - United States, 1973 and Belgium, 1973: more extreme outcomes in some cases (US: surge driven by 1970s oil embargo; Belgium: marked surge partly from widespread wage indexation).
    - US 1946–48: postwar release of pent-up demand and lifting of price controls produced about 20 percent year-over-year inflation and wage growth by 1947:Q1, followed by gradual declines and a sharp drop in inflation by late 1948.
  - Monetary policy tightening followed most past episodes: out of 22 illustrated episodes, 13 were followed by monetary policy tightening.

### Empirical approach, wage Phillips curve, and caveats
- Empirical framework: wage Phillips curve relating wage growth to inflation expectations, labor market slack, and productivity growth; baseline uses unemployment rate and its change as slack measures (sample 2000:Q1–19:Q4 for 31 advanced and 15 emerging market economies in estimation reported).
- Key magnitudes:
  - Advanced economies: a 1 percentage point increase in inflation expectations is associated with a close to 1 percentage point increase in wage growth.
  - Emerging market economies: a 1 percentage point increase in inflation expectations is associated with a 0.6 percentage point increase in wage growth.
- Robustness: negative relationship with unemployment robust to other slack measures (including unemployment gaps and unemployment-to-vacancy ratio in robustness checks).
- Structural features matter: higher employment protection stringency and greater firm markups can increase wage responsiveness to slack and expectations; union density and centralized bargaining can increase pass-through of inflation shocks to wages.
- Caveats:
  - Data availability constrains empirical analysis; sample coverage differs across exercises.
  - Methods are associational rather than strictly causal.
  - Historical analyses may not fully represent current circumstances if COVID-19 induced structural breaks; model-based analysis allows limited regime shifts via adaptive learning.

### Model-based historical decomposition (selected findings)
- Model: multi-economy, multisector general equilibrium model with nominal rigidities and credit constraints; seven shock types analyzed (production capacity/labor supply, international trade costs, commodity prices, private saving behavior, consumption composition changes, fiscal policy support, monetary policy support).
- Commodity price changes in 2021: energy and food prices went up by 85 percent and 20 percent year over year, respectively, in 2021.
- For the United States, euro area, and Mexico (2020–2021):
  - Reductions in production capacity were the predominant contributors to nominal wage changes during 2020 and 2021.
  - Changes in households’ saving behavior were among the most important drivers of price changes over the same years.
  - Results imply future paths for wages and prices depend heavily on how these shocks unwind or whether new shocks arise.
- Model notes: impacts of individual shocks do not necessarily add up to the total because of general equilibrium interactions; total model-based impacts are broadly aligned with but not exactly equal to actual outturns.

### Inflation de-anchoring empirical evidence (local projections)
- Empirical strategy uses local projections to estimate effects of inflationary shocks and monetary tightening on wages and prices; inflationary shocks proxied by the Federal Reserve Bank of New York’s Global Supply Chain Pressure Index interacted with trade openness; monetary tightening estimated using identified ECB shocks.
- Key empirical outcomes for a one-standard-deviation increase in global supply chain pressures:
  - The inflation response outstrips nominal wage growth.
  - Both realized and short-term expected inflation increase persistently, taking three years (beyond the horizon shown) before reverting to long-term means.
  - Nominal wage growth increases slightly in the very near term then deteriorates as activity weakens, leading to a fall in real wage growth.
  - No signs that such inflationary shocks kick off a wage-price spiral.
- Monetary tightening:
  - Brings inflation down and depresses nominal wage growth.
  - The effect of a one-standard-deviation monetary tightening on realized and expected inflation is shorter lived than that of a supply chain shock.
  - Nominal and real wage growth decline and unemployment and long-term government bond rates increase in response.
- Supply-chain-related shocks have more prolonged effects on expected inflation than monetary tightening, implying monetary policymakers may need aggressive responses when inflation is high and rising.

### Expectations formation, model scenarios, and policy implications
- Expectations processes considered:
  1. Rational expectations.
  2. Fully adaptive expectations (agents expect future variables equal to latest realization).
  3. Adaptive learning (agents use small statistical models and update as data arrive).
- Small dynamic stochastic equilibrium model includes price and wage Phillips curves, an investment–savings curve, and a monetary policy reaction function.
- United States scenario (no new shocks; interest rates follow Federal Reserve dot plot as of June 2022):
  - Rational expectations:
    - Soft landing feasible; current inflationary shock dissipates over 12 quarters; output gap converges to zero and core inflation comes down to Federal Reserve target of 2 percent.
  - Fully adaptive expectations:
    - Fast near-term acceleration in wage and price inflation because agents expect variables to equal recent elevated realizations.
    - As shocks dissipate, price inflation declines but remains 1.5 percentage points over target even 12 quarters later.
    - To bring inflation down more quickly under fully adaptive expectations, monetary policy would need to tighten much more sharply than currently anticipated.
  - Adaptive learning:
    - Paths lie between rational and fully adaptive outcomes; greater inertia than rational expectations but far less than fully adaptive expectations.
    - Output gap mostly closes; inflation remains about half a percentage point above target after 12 quarters.
- Emerging market example (Brazil) shows greater sensitivity to inflationary shocks and higher de-anchoring risks, suggesting potentially stronger central bank reactions are needed.

### Role of real wages and assessment of wage-price spiral likelihood
- In the model, wages are the only determinant of marginal costs; real wage dynamics are central because they affect price pressures.
- Negative real wage gaps (real wages falling relative to productivity) help anchor inflation when cost-push shocks occur: falling real labor costs reduce price pressures.
- Overall assessment:
  - Supply-chain-related inflationary shocks have temporary effects and do not by themselves give rise to a wage-price spiral in the scenarios examined.
  - If inflation expectations become less anchored (more backward-looking), stronger and quicker monetary policy responses are required to reduce de-anchoring risks.
  - Adaptive expectations increase the need for more aggressive tightening to reach targets, but the likelihood of a persistent wage-price spiral remains low in the scenarios studied—absent more persistent shocks or structural changes in wage- and price-setting.

### Box 2.1 — Pass-through from wages to prices (United States)
- Method: disaggregated sectoral data and input-output approach tracing cumulative labor input costs through supply chains for 73 PCE subcomponents; local projection method controlling for sectoral productivity and fixed effects.
- Aggregate finding: recent pickup in nominal wage growth has added only modestly to consumer price inflation, mainly via certain services prices.
- Estimated pass-through magnitudes:
  - Pass-through to services: about 10 percent after five quarters (response to a 1 percentage point change in current wage growth).
  - Pass-through to goods: no measurable pass-through detected.
  - Pre-2020 conditional effect: contemporaneous pass-through in services rises to 20 percent (statistically significant at the 99 percent confidence level) when wage growth is at or above the 75th percentile (that is, 3.9 percent).
  - In lower wage-growth periods, pass-through to services is about zero.
- Model scenarios and expectations:
  - More backward-looking expectations increase inertia and the need for front-loaded monetary tightening.
  - With cost-push shocks outside the labor market, real wage dynamics help stabilize inflation even with adaptive expectations; if policy is insufficiently responsive, inflation and expectations can de-anchor under adaptive expectations.
  - Optimal policy under adaptive learning (objective equally weights output and inflation deviations with some policy-rate smoothing) is to front-load tightening to reduce buildup of inflation expectations and reach target more quickly and smoothly.
- Key implications:
  - Real wages were on average flat or falling during the recent inflation pickup, which can be disinflationary by lowering firms’ real costs.
  - Historical episodes with similar features typically did not lead to wage-price spirals; inflation tended to fall gradually and nominal wages caught up over several quarters.
  - Wage dynamics in 2020–21 were initially poorly explained by expectations and slack, but by second half of 2021 aligned more closely, suggesting a possible return toward normal dynamics contingent on shock unwinding.
  - Macro-level link between labor cost and price inflation has weakened over three decades; disaggregated evidence is mixed.

*Source: ch2 — CHAPTER 2 — WAgE DYNAMICs POsT–COvID-19 AND WAgE-PRICE sPIRAL RIsKs (ch2).*

### Introduction

### ch2 - Introduction

### Overview of recent wage, price, and labor dynamics
- With the recovery picking up steam after the acute COVID-19 shock, inflation in 2021 started hitting levels that had not been seen in almost 40 years in many economies.
- Factors underpinning sharp rises in prices include pandemic-related supply chain disruptions, commodity price shocks, expansive monetary policy and fiscal support, a surge in pent-up consumer demand, and changes in consumer preferences for goods versus services.
- Labor demand resurged in many sectors while labor supply was slow to respond (workers hesitant to reengage because of ongoing health concerns and difficulties finding child and family care, among other factors). This produced tighter labor markets and increased wage pressures, with average nominal wages (per worker) rising and the unemployment rate falling beginning in the second half of 2020 across economy groups.
- Growth in nominal wages mostly brought the average level in 2021 back to the pre-pandemic trend, although nominal wage growth in 2021 did not fully keep up with price inflation. As a result, real wages (nominal wages deflated by consumer prices) were fairly flat or falling.
- These nominal and real wage patterns continued into the first quarter of 2022 for economies for which data are available.
- At a sectoral level, nominal wages in both industry and services tended to converge to their common pre-pandemic trends across economy groups. Sectoral employment shifts appear to contribute little to overall wage changes through the end of 2021—the common changes in wages across sectors account for the lion’s share of the average overall wage change.

### Definition and concern about wage-price spirals
- A wage-price spiral is defined here as an episode of several quarters characterized by accelerating wages and prices (that is, in which both wage and price inflation rates rise simultaneously).
- The central question is whether recent wage and price dynamics could evolve into a persistent wage-price spiral, driven by changes in inflation expectations and tighter labor markets prompting sustained worker demands for higher wages.

### Key analytical questions addressed
- How do wage, employment, and price dynamics in the recovery from the COVID-19 shock compare with pre-pandemic dynamics? Did historical episodes mirroring 2021 patterns in wages, employment, and prices in advanced economies subsequently evolve into wage-price spirals?
- How well do inflation expectations and labor market conditions explain recent nominal wage growth in advanced and emerging market and developing economies? What were the deeper, underlying drivers of wages, prices, and employment during 2020–21?
- Could wage and price pressures in the wake of COVID-19 lead to high and persistent wage and price inflation? Historically, has monetary tightening been effective in reducing wage and price pressures? How could changes in the formation of wage and price expectations affect prospects, and how should policymakers take them into account?

### Main findings (as presented in the chapter)
- Both wage and price inflation picked up in a broad-based manner through 2021, while real wages have tended to be flat or falling across economies on average. At a sectoral level, nominal wages in both industry and services tended to converge to their common pre-pandemic trends across economy groups. Consequently, sectoral employment shifts appear to explain little of overall wage changes through the end of 2021.
- On average, wage-price spirals did not follow historical episodes that were similar to the circumstances currently seen in advanced economies. Although the COVID-19 shock is unusual and the current conjuncture unlike much recent experience, similar historical episodes of inflation in advanced economies—in which real wages were flat or falling—did not tend to entail a wage-price spiral. In fact, inflation tended to fall in the aftermath while nominal wages gradually caught up.
- Changes in inflation expectations and labor market slack explain wage dynamics in the second half of 2021 relatively well. In the immediate aftermath of the COVID-19 shock, wage growth across economies was poorly explained by its earlier empirical relationship with expectations and unemployment. However, by the end of 2021, wage growth was broadly in line with the increases in inflation expectations and labor market tightening observed across economy groups on average.
- Reflecting the pandemic shock’s unusual nature, a complex mix of supply and demand shocks underpinned the 2020–21 behavior of wages and prices. Using a rich multi-sector, multi-economy structural model, the chapter finds that over the two years since the pandemic’s onset, wages have been driven predominantly by production capacity and labor supply shocks (from social distancing and lockdowns), while prices have been more affected by private saving and the release of pent-up demand. How and when (or if) these deeper shocks unwind will matter for how wage and price inflation develop.
- When wage and price expectations are more backward-looking, monetary policy actions need to be more front-loaded to minimize the risks of inflation de-anchoring. Scenario analysis using a newly developed model of expectations and wage and price setting suggests the observed decline in real wages has acted as a drag so far, reducing price pressures and helping inhibit development of a wage-price spiral dynamic. However, the more backward-looking (adaptive) expectations are, the greater the chances that inflation could de-anchor to a higher-than-target level. The monetary policy response should depend on the nature of wage and price expectations: the more backward-looking they are, the quicker and stronger the tightening needed to avert inflation de-anchoring and prevent large declines in the real wage.

### Historical episode evidence
- A sample of advanced economies covering the past 40 years (and for a few the past 60 years) reveals 22 other episodes exhibiting similar conditions to the COVID-19 recovery episode. The sample comprises 30 advanced economies for which data on inflation, wages, prices, and unemployment are available at a quarterly frequency going back to 1960 at the earliest.
- Selection criteria for these episodes: at least three out of the previous four quarters had (1) rising inflation, (2) positive nominal wage growth, (3) declining real wages, and (4) declining or flat unemployment. If the criteria hold for several quarters within three years, only the first episode in which the criteria held is selected.
- Similar past episodes were not followed by a wage-price spiral. Nominal wage growth tended to increase somewhat after these episodes, but inflation edged down on average, leading to an increase in real wages. The unemployment rate generally stabilized after the episodes.
- There is heterogeneity across historical episodes. Notable outliers:
  - United States, second quarter of 1979: inflation rose rapidly for four quarters before starting to decline; unemployment rose more than in other identified episodes. Underlying the changes was aggressive monetary tightening (the Volcker disinflation). Nominal wage growth was relatively flat during this period, leading to a decline in real wages early on; as inflation came down, the deterioration in real wages decreased.
  - Episodes such as the US episode starting in 1973 and Belgium in 1973 experienced more extreme outcomes in some cases (US: price inflation surged for five additional quarters driven by the 1970s oil embargo; Belgium: both nominal wage growth and price inflation surged markedly, partly owing to widespread wage indexation).
  - Farther back, US 1946–48: after World War II, price controls were lifted and pent-up demand was released; price inflation and nominal wage growth picked up during 1946, both reaching about 20 percent year over year by the first quarter of 1947. Thereafter inflation and wage growth started to come down gradually while remaining high for about a year; inflation then came down sharply in the latter half of 1948 into early 1949 as supply chains readjusted and pent-up demand became exhausted (with a mild recession in 1949).
- Overall, historical evidence suggests episodes characterized by about a year of accelerating prices and wages have not generally lasted; nominal wage growth and price inflation tended to stabilize on average, though inflation and wage growth remained elevated for several quarters after these past episodes.
- Monetary policy tightening followed most of the past episodes: out of the 22 episodes illustrated, 13 were followed by monetary policy tightening. The evidence suggests an appropriate monetary policy response can contain the risks of a subsequent wage-price spiral in the current circumstances to very low levels.

### Empirical approach and caveats
- The chapter studies wage drivers using the wage Phillips curve framework, relating wage growth to inflation expectations, labor market slack, and productivity growth. It first examines the pre–COVID-19 wage-setting process and then evaluates whether that framework explains recent dynamics.
- Important caveats:
  - Empirical analysis is constrained by data availability across economies and over time; exact sample coverage differs across exercises.
  - Empirical methods used are standard, but findings should be interpreted as associational rather than causal.
  - Historical analyses may not be fully representative of the current circumstances if the COVID-19 shock caused a large structural break (for example, shifts in expectations formation or wage-setting). The model-based analysis of expectations allows for a limited form of regime shifts in its examination of adaptive learning, providing some insurance against structural breaks.

*Source: ch2 - Introduction*

### Annex 2.3 for additional information.

### Annex 2.3 for additional information

### Specification and methodology
- Specification based on Chapter 2 of the October 2017 World Economic Outlook and inspired by Galí (2011) micro-founding of the wage Phillips curve as the outcome of a wage-setting process.
- Baseline specification uses the unemployment rate and its change as measures of labor market slack to permit wider coverage of advanced and emerging market economies.
- Online Annex 2.4 includes details on the baseline specification and robustness checks (including lagged inflation and alternative slack measures).
- Episodes identification for Figure 2.3: at least three of the preceding four quarters have (1) accelerating prices/rising price inflation and (2) accelerating nominal wages/rising nominal wage growth. Seventy-nine such episodes identified within a sample of 30 advanced economies, the earliest going back to 1960.
- Sample and estimation for wage Phillips curve (Figure 2.4, panel 1): 2000:Q1–19:Q4, consisting of 31 advanced and 15 emerging market economies. Whiskers indicate 90 percent confidence intervals.

### Empirical findings: wage Phillips curve relationships
- Inflation expectations and productivity growth are associated with increases in nominal wage growth; increases in labor market slack (unemployment rate and its change) are correlated with slower wage growth. Relationships statistically significant in both advanced and emerging market economy groups.
- Magnitudes:
  - Advanced economies: a 1 percentage point increase in inflation expectations is associated with a close to 1 percentage point increase in wage growth.
  - Emerging market economies: a 1 percentage point increase in inflation expectations is associated with a 0.6 percentage point increase in wage growth.
- Relationship with inflation expectations weakened in the period after the global financial crisis when inflation was remarkably low and stable.
- Negative relationship with unemployment robust to other slack measures, including unemployment gaps and, in robustness checks, the unemployment-to-vacancy ratio (US evidence suggests the unemployment-to-vacancy ratio performed better in explaining recent wage growth).
- Emerging market wages can be more sensitive than advanced-economy wages to changes in labor market and productivity conditions, although past experience varies substantially.

### Role of structural characteristics in wage dynamics
- Employment protection stringency:
  - In economies with more stringent employment protections, wage growth appears on average more sensitive to changes in labor market slack (unemployment) and inflation expectations.
- Firm markups (product market power):
  - In economies where firms exhibit greater market power (higher average price markup), wages appear slightly more responsive to unemployment changes.
- Related literature: higher union density and higher degree of centralized bargaining can increase pass-through of inflation shocks to wages (Baba and Lee 2022); structural, regulatory, and institutional features affect wages’ responsiveness.

### Pandemic deviations and wage behavior since 2019
- Wage dynamics during the acute COVID-19 phase were highly unusual and did not closely follow the wage Phillips curve; abrupt swings deviated from those explained by inflation expectations and unemployment changes.
- Deviations partly due to movements in hours worked (intensive margin adjustments) and large temporary layoffs concentrated among lower-paid workers.
- Cross-economy heterogeneity:
  - At the pandemic start, the drop in wage growth was less prominent than predicted by inflation and unemployment movements in advanced economies (particularly the US), while the opposite was true in emerging markets.
  - Worker composition shifts (e.g., greater employment losses among low-wage workers in the US) pushed average wages upward at the start of the pandemic.
- By end-2021, recovery of wage growth in both advanced and emerging market economies largely aligned with observed drops in unemployment and increases in inflation expectations, with a shrinking residual contribution. The rise in inflation expectations appears to account for more of the very latest movements in wage growth.
- Chapter 1 provides evidence on the average and distribution of inflation expectations in 2022 for selected economies.

### Model-based historical decomposition: supply and demand shock contributions
- A multi-economy, multisector general equilibrium model (nominal rigidities and credit constraints) was used to decompose drivers of wage, price, and employment changes. Model builds on Baqaee and Farhi (2022a, 2022b) and Gourinchas and others (2021).
- Seven types of shocks considered:
  - Supply-side shocks:
    - Production capacity (or labor supply) shocks from lockdowns/social distancing, calibrated to changes in hours worked by sector.
    - International trade cost shocks measured by shipping costs by product for US imports.
    - Commodity price changes for energy and food: energy and food prices went up by 85 percent and 20 percent year over year, respectively, in 2021.
  - Demand-side shocks:
    - Changes in private saving behavior, calibrated via households’ discount rate to track saving rates.
    - Consumption composition changes (reallocation from services toward goods), derived from changes in expenditure shares.
    - Fiscal policy support (changes in government consumption and spending on unemployment insurance).
    - Monetary policy support, calibrated to observed central bank policy rates.
- Historical decomposition results (United States, euro area, Mexico) for 2020 and 2021:
  - Reductions in production capacity were the predominant contributors to nominal wage changes during 2020 and 2021.
  - Changes in households’ saving behavior were one of the most important drivers of price changes over the same years.
  - These results imply future paths for wages and prices could depend heavily on how these shocks unwind or whether new shocks arise.
- Model notes:
  - Impacts of individual shocks do not necessarily add up to the total impact because of general equilibrium interactions.
  - Total model-based impacts are broadly aligned with but not exactly equal to actual outturns.
  - Economies studied were selected based on economic size, data availability for calibration, and diversity of policy responses.

*Source: Annex 2.3*

### CHAPTER 2

### CHAPTER 2 WAgE DYNAMICs POsT–COvID-19 AND WAgE-PRICE sPIRAL RIsKs

### Drivers of wages, employment, and prices in 2020–2021
- 2020:
  - Main determinant across the three economies was the drop in production capacity early in the pandemic, which reduced labor supply and translated into decreases in employment and an increase in hourly wages.
  - Rise in private saving was a contractionary force for aggregate demand, producing a disinflationary impact on nominal wages and consumer prices, particularly in the United States.
  - Expansive fiscal and monetary policy responses in the United States and the euro area limited early damages to employment and helped support nominal wages.
  - Fiscal policy support in Mexico shrank in 2020, pulling wages and prices down to some extent. Monetary policy expansion in Mexico sustained employment and pushed nominal wages and prices up.
  - For all three economies, the combination of a sharp increase in nominal wages and muted price responses led to strong increases in real wages.
- 2021:
  - Main driver was a rebound in aggregate demand running ahead of production capacity (a supply–demand imbalance).
  - Private savings began to be drawn down, reversing the negative demand impact from 2020 and raising consumer prices.
  - Production capacity recovered somewhat (especially in the euro area and Mexico) but not enough to fully boost employment as cumulative impact remained negative.
  - Continued monetary accommodation in the United States pushed wages and prices up further; monetary support effects on inflation were reduced in the euro area and Mexico.
  - Fiscal policy support decreased across economies in 2021 compared with 2020, relieving some earlier upward pressure on prices.
  - Steep rise in commodity prices in 2021 acted as a drag on employment and raised economy-wide prices more in the euro area and Mexico than in the United States; commodity prices rose further in 2022, increasing inflationary pressure.

### Inflation de-anchoring: expectations and policy responses — empirical evidence
- Empirical strategy:
  - Uses local projections to estimate dynamic effects of inflationary shocks and monetary tightening on wages and prices.
  - Inflationary shocks proxied by the Federal Reserve Bank of New York’s Global Supply Chain Pressure Index, interacted with trade openness by economy.
  - Monetary policy tightening estimated using identified European Central Bank monetary shocks from Jarociński and Karadi (2020).
- Key empirical findings:
  - For a one-standard-deviation increase in global supply chain pressures:
    - The inflation response outstrips nominal wage growth.
    - Both realized and short-term expected inflation increase persistently, taking three years (beyond the horizon shown) before reverting to their long-term means.
    - Nominal wage growth increases slightly in the very near term then deteriorates as activity weakens, leading to a fall in real wage growth.
    - No signs that such inflationary shocks kick off a wage-price spiral.
  - Monetary tightening:
    - Brings inflation down and has similar depressive effects on nominal wage growth.
    - The impact of a one-standard-deviation monetary tightening on realized and expected inflation is shorter lived than the effect of a supply chain shock.
    - Nominal and real wage growth decline and unemployment and long-term government bond rates increase in response.
  - Supply-chain-related inflationary shocks have more prolonged effects on expected inflation than monetary tightening, suggesting monetary policymakers may need to respond aggressively to such shocks when inflation is high and rising.

### Expectations formation and model scenarios
- Expectations formation processes considered:
  1. Rational expectations: agents understand the economy’s full structure and make forecasts that are correct on average in the absence of further shocks.
  2. Fully adaptive expectations: agents project future variables to be exactly equal to their latest realization.
  3. Adaptive learning: agents form expectations using small statistical models, updating as new data arrive and learning from past errors.
- Small dynamic stochastic equilibrium model components:
  - Price and wage Phillips curves, an investment–savings curve, and a monetary policy reaction function.
- United States scenario (no new shocks; interest rates follow Federal Reserve dot plot as of June 2022):
  - Rational expectations:
    - A soft landing appears feasible; the current inflationary shock is assumed to dissipate smoothly over the subsequent 12 quarters.
    - Output gap converges to zero and core inflation comes down to the Federal Reserve’s target of 2 percent.
  - Fully adaptive expectations:
    - Fast near-term acceleration in wage and price inflation because agents expect variables to equal their most recent (elevated) realizations.
    - As shocks dissipate, price inflation declines but remains 1.5 percentage points over target even 12 quarters later.
    - To bring inflation down more quickly under fully adaptive expectations, monetary policy would need to tighten much more sharply than currently anticipated.
  - Adaptive learning:
    - Paths of inflation, wage growth, and the output gap lie between rational and fully adaptive outcomes.
    - Greater inertia than rational expectations but far less than fully adaptive expectations.
    - Output gap mostly closes; inflation remains about half a percentage point above target after 12 quarters.
- Findings for an emerging market (Brazil) resemble the United States but show greater sensitivity to inflationary shocks and higher risks of de-anchoring, suggesting potentially stronger central bank reactions are needed.

### Role of real wages and the likelihood of a wage-price spiral
- In the model, wages are the only determinant of marginal costs.
- Real wage dynamics are central to the evolution of wage and price inflation because real wages affect price pressures.
- When inflationary cost-push shocks occur, the negative real wage gap (real wages falling relative to productivity) helps anchor inflation even under fully adaptive expectations.
  - Falling real labor costs help bring inflation down; larger increases in inflation produce more negative real wage gaps and a more powerful anchoring mechanism.
- Overall assessment:
  - Empirical and model evidence indicate supply-chain-related inflationary shocks have temporary effects and do not, by themselves, give rise to a wage-price spiral.
  - However, if inflation expectations become less anchored, stronger monetary policy responses are required to reduce risks of de-anchoring.
  - Adaptive (backward-looking) expectations increase the need for more aggressive monetary tightening to reach inflation targets, but the likelihood of a persistent wage-price spiral remains low in the scenarios examined.

*Source: CHAPTER 2 — WAgE DYNAMICs POsT–COvID-19 AND WAgE-PRICE sPIRAL RIsKs (ch2 - CHAPTER 2).*

### Box 2.1 empirically examines the feedback from wages

### Box 2.1: Pass-Through from Wages to Prices — Estimates from the United States

### Overview
- The box uses disaggregated sectoral data and an input-output approach to trace cumulative labor input costs through supply chains for 73 subcomponents of the PCE index.
- Empirical approach: local projection method in Heise, Karahan, and Şahin (2020), controlling for sectoral productivity growth and time and industry fixed effects.
- Main empirical challenge addressed: matching final consumer prices (PCE) to industry-level labor input costs via input-output matrices.

### Empirical findings on wage-to-price pass-through
- Aggregate result: recent pickup in nominal wage growth has added only modestly to consumer price inflation, mainly via certain services prices.
- Estimated pass-through magnitudes:
  - Pass-through to services: about 10 percent after five quarters (response to a 1 percentage point change in current wage growth).
  - Pass-through to goods: no measurable pass-through detected.
- Heterogeneity and conditional effects:
  - Pre-2020 evidence: contemporaneous pass-through in services rises to 20 percent (statistically significant at the 99 percent confidence level) when wage growth is at or above the 75th percentile (that is, 3.9 percent).
  - In periods with lower wage growth, pass-through to services is about zero.
  - Cross-sectional sectoral data suggest the point estimate of pass-through from wages to service prices has been increasing since 2021:Q1 but is not statistically significant.

### Model-based scenarios: expectations and monetary policy
- Expectations formation matters critically:
  - More backward-looking (adaptive) expectations increase economic inertia through greater inertia in expectations themselves.
  - With cost-push shocks originating outside the labor market, real wage dynamics help stabilize inflation even when expectations are adaptive; however, if policy is insufficiently responsive, inflation and inflation expectations can de-anchor the more adaptive expectations are.
- Scenario exercises calibrated to the United States (horizontal axes measured in quarters since 2021:Q4; inflation is core inflation):
  - Adaptive learning baseline vs. fully adaptive expectations vs. rational expectations show differing near-term paths for inflation, inflation expectations, nominal wage growth, real wage gap, output gap, and interest rate.
  - Under positive output gap and persistent cost-push shocks, a central bank that minimizes a standard welfare function would choose to initially tighten policy more and start easing earlier than the Federal Reserve’s June 2022 dot plot (Figure 2.10).
- Channels through which monetary policy affects inflation dynamics:
  1. Higher interest rates lower the output gap and real wages via wage and price Phillips curves.
  2. With partially adaptive expectations, lower inflation realizations reduce expected inflation.
  3. Businesses and households, recognizing forecasting mistakes, learn over time and place less weight on past outcomes when forming expectations.
- Optimal policy under adaptive learning (objective equally weights output and inflation deviations, with some weight on policy-rate smoothing): front-loading monetary policy tightening is optimal to lessen buildup of inflation expectations and help achieve target more quickly and smoothly.

### Key implications and conclusions
- Real wages on average were flat or falling across economies during the recent inflation pickup, which can be disinflationary by lowering firms’ real costs.
- Historical episodes with features similar to the current conjuncture did not typically lead to wage-price spirals; inflation tended to fall gradually and nominal wages catch up over several quarters, though in some cases inflation remained elevated for a while.
- Wage dynamics in 2020–21 were poorly explained by inflation expectations and labor market slack, reflecting COVID-19–related shocks; in the second half of 2021 wage growth aligns more with expectations and slack, suggesting a possible return toward normal dynamics contingent on shock unwinding.
- The empirical literature offers limited evidence of wage-to-price pass-through; at the macro level the link between labor cost and price inflation has weakened over three decades, and disaggregated evidence is mixed.
- Conditional risks:
  - If expectations are more backward-looking, monetary policy must be more front-loaded to minimize de-anchoring risks.
  - Under the scenario analysis, tighter monetary policy and resulting declines in real wages reduce price pressures, containing the risk of a persistent wage-price spiral on average—assuming no more persistent inflationary shocks or structural changes in wage- and price-setting (for example, sharply higher pass-through in either direction).

*Source: IMF staff calculations, Box 2.1, Chapter 2, World Economic Outlook: Countering the Cost-of-Living Crisis (excerpt).*

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_Source: https://www.imf.org/-/media/files/publications/weo/2022/october/english/ch2.pdf_