Wage-Price Spiral Risks Appear Contained Despite High Inflation

IMF Blog, October 5, 2022

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Inflation in some economies is rising at the fastest pace in four decades.
Analysis suggests a sustained acceleration of wages and prices (a wage-price spiral) is unlikely on average.
Three factors are working together to contain risks:
- the underlying shocks to inflation are coming from outside the labor market,
- falling real wages are helping to reduce price pressures,
- central banks are aggressively tightening monetary policy.

Identified 22 situations in advanced economies over the past 50 years with conditions similar to 2021: price inflation rising, wage growth positive, but real wages and the unemployment rate flat or falling.
On average, these episodes did not lead to wage-price spirals; instead:
- inflation came down in subsequent quarters,
- nominal wages gradually rose, helping real wages recover.
Heterogeneity across episodes exists; for example:
- in the United States after 1979, inflation kept rising and real wages fell for a while following further oil price hikes,
- the inflation trajectory changed only when the Federal Reserve raised interest rates sharply.

Inflation expectations became more important in explaining wage dynamics over the second half of 2021, according to an empirical analysis.
Model-based analysis calibrated to reflect economic conditions in the first half of this year and taking the policy rate path as given finds differing outcomes depending on expectation formation:
- Fully adaptive (expect future inflation to equal today’s): can lead inflation to rise and stay above the central bank’s inflation target for a prolonged period even without additional price shocks.
- Rational (expectations reflect all available information): treats shocks as temporary, leading wage growth and inflation to quickly move back towards target and stay anchored.
- Adaptive learning (reality between extremes; recent quarters weighed more heavily): wage growth and inflation take longer to return to target than under rational expectations, but faster than under fully adaptive expectations.
In all expectation scenarios, real wages tend to fall initially as inflation outstrips wage growth, which helps offset some of the cost-push shock and works against a wage-price spiral.
A labor-market-originating inflationary shock (for example, an unexpected, sharp uptick in wage indexation) could moderate the effects of falling real wages and push up both wage growth and inflation for longer.

For monetary policymakers, understanding the expectations process is critical:
- When expectations are more backward-looking, monetary policy tightening—including through clear communications by the central bank—should be stronger and more front-loaded in response to an inflation shock.
Recent tightening actions by many central banks—calibrated to economy-specific circumstances—are encouraging and will help to:
- prevent high inflation from becoming entrenched,
- prevent inflation from deviating from target for too long.

This blog is based on Chapter 2 of the October 2022 World Economic Outlook, “Wage Dynamics Post-COVID-19 and Wage-Price Spiral Risks.”