Energy Shocks Amid Rapid Inflation Could Fuel Faster Wage Gains

IMF Blog, September 12, 2022

Source details

Canonical URL: Energy Shocks Amid Rapid Inflation Could Fuel Faster Wage Gains

High oil and energy prices raise costs for consumers directly (fuel, airfare) and indirectly (higher prices for goods), eroding purchasing power and prompting workers to seek higher wages.
These wage responses to energy price shocks are examples of "second-round effects" that can feed back into higher overall prices and potentially create a wage-price spiral if large and sustained.
Study basis: analysis of 39 European countries.

When overall inflation is already high, wages tend to rise more in response to an oil price shock.
Quantified effect: wages increase by 0.4 percent one year after a 10 percent increase in oil prices when underlying inflation is higher than 4 percent.
By comparison, wages increase by less than 0.2 percent one year after a 10 percent increase in oil prices when underlying inflation is not higher than 4 percent.
The difference in wage response between high- and low-inflation periods narrows in the second year.
Even in high-inflation environments, wages tended to stabilize after a year rather than continuing to rise steadily, implying a rise in the wage level but not a continued increase in wage inflation.

Higher underlying inflation may make people more alert to price increases and more likely to demand compensation for energy-driven cost increases.
Larger second-round effects increase the risk of a sustained feedback loop between wages and prices, which could raise inflation expectations and prolong inflationary pressures.

Because oil price shocks can fuel persistent rises in inflation and inflation expectations if second-round effects are large and sustained, a monetary policy response is required to counter this risk.
Central banks need to respond firmly to head off the risk of sizable second-round effects leading to a sustained increase in inflation.
If central banks remain adequately vigilant, current high inflation could cause higher-than-usual compensation for the cost of living without necessarily morphing into a sustained increase in inflation.

Chikako Baba and Jaewoo Lee — September 12, 2022