Inflation, Wages, and Monetary Policy

Ioannis Tyrchides

Inflation has been rising for the past year or so, reaching levels seen during the 1970s and early 1980s stagflation more than 40 years ago. That is the source of our fear. If, as many fear, current inflation proves to be sustained and inflation expectations begin to loosen, the monetary tightening cycle will be longer and steeper. And there is no magic in raising interest rates and reducing the money supply. It halts the credit process and slows down economic activity. As a result, growth will be slow or even negative and unemployment will be high. Inflation eases as aggregate demand falls and a recession sets in. But there is as yet no strong evidence that so-called secondary effects are causing more persistent inflation. Wages, raw material inputs, including energy of course, and profits are all costs and are included in the final price. We do not know whether the non-energy and non-food inflation we have observed is demand driven or cost driven. Each means different things for monetary policy. This article takes a critical look at the current inflation experience through a 1970s rearview mirror.

The current institutional and policy framework regarding inflation is a direct legacy of the 1970s. This primarily meant an independent central bank and inflation targeting, now central to economic organization and policy making.

In short, the 1970s were a time of chaos and anarchy. It was marked by war, a series of oil shocks, class struggles, and ultimately a global recession. America’s involvement in the Vietnam War lasted from 1964 to 1972, leading to significant budget deficits and a buildup of debt. The Arab-Israeli War of 1973 resulted in an oil embargo and an oil shock, followed by a series of oil shocks over the next decade. Between 1973 and his 1980, oil prices rose more than ten times hers. This was an unprecedented breakthrough for the world economic order at the time, especially given that oil prices remained virtually unchanged in post-inflation terms between 1946 and 1972.

Class struggle was also prevalent, especially in the United States and Great Britain. Labor was organized and trade unions had considerable bargaining power. Wage indexation became widespread. A situation of excess demand caused by prolonged deficit spending and accommodative monetary policy coincided with the oil shock that covered the period. This supported a so-called wage-price spiral, in which inflation leads to higher wages, which in turn leads to higher prices, leading to further wage increases in a potentially destabilizing loop. Inflation in the US peaked at 13.6% in 1980 and averaged 9.4% annually from 1974 to 1981. The same was true in Europe, and even worse in the UK, where inflation exceeded her 25% in 1975. Under Paul Volcker, the Federal Reserve implemented aggressive monetary tightening, eventually raising interest rates to his 19%, triggering a massive recession in both the US and Europe.

What the 1970s taught us was the importance of acting quickly and decisively to prevent rising inflation expectations. According to economic theory, inflation expectations among workers and industries play a key role in driving out of control wage and price increases. This lesson has implications for central bank policy today.

Inflation today is markedly different than it was in the 1970s. The energy crisis is less severe, the labor force is weaker, and the bargaining power to raise wages significantly is limited. Our economic organization is also very different, emphasizing low inflation and prudent macroeconomic policies.

So far, inflation has been largely a supply phenomenon. Contribution from the demand side has been limited due to the impact of the Covid-19 pandemic and is likely now gone. Second-order effects are similarly limited, with no wage-price spiral, at least for now. This suggests inflation will fall unless the energy and food crises worsen. The reason the Federal Reserve and ECB are raising rates so urgently is because they recognize the need to anticipate rising inflation expectations very early on.

The Federal Reserve ended monetary easing in March and raised the Fed Funds Rate by 2.25 percentage points at four policy meetings in March, May, June and July from March to July. The Federal Fund’s target rate is currently between 2.25% and 2.5%. After this tightening cycle is over, the market expects interest rates to rise further for the remainder of this year and next year, reaching 3.5%.

In Europe, the European Central Bank ended quantitative easing in June and raised key interest rates by half a percentage point in July. This is his first rate hike in 11 years and the ECB is widely expected to continue raising rates at each of the remaining Policy Board meetings until the end of the year. The main refinancing rate will probably rise to 1.5% by December and 2% by March next year, barring financial troubles in the meantime.

Inflation has soared so far this year. Across the European Union, the Harmonized Index of Consumer Prices rose 7.7% in the first half of this year, compared with his 1.8% rise in the same period last year. Energy and electricity saw strong increases of 35% and 29% respectively, both up 5.6% over the previous year. Grocery prices were up 8%, after little gain in the previous year. Excluding energy from the all-commodities index therefore reduces inflation to 4.6% from 1.3% a year earlier. Also, when food prices are excluded in addition to energy, the overall index increase slows to 3.8% from 1.4% a year earlier. In conclusion, inflation in the first six months of the year was largely driven by energy, followed by food. However, non-energy and non-food inflation remained higher than last year. For example, service prices rose 3.6% from 1.6% last year. However, it is not yet clear whether this is due to demand or cost.

What happens next depends on the side effects and the degree to which wage and price spirals materialize or the energy and food crises spiral out of control. In the current climate of geopolitical uncertainty and open competition between great powers, and war, oil and energy markets, let alone food, cannot function normally, especially with Russia under a tough sanctions regime. I can’t imagine going back. Therefore, given supply constraints and high risks in global markets, the recent drop in oil and gas prices may be short-lived. Similarly, if the energy and food prices that contributed to this inflation remained at current levels and did not rise significantly, inflation would begin to recede and eventually begin after this fall. There will be cost of living issues related to energy prices remaining higher than pre-COVID levels, but that’s another issue.Inflation after the energy crisis subsides

Easing, monetary policy is easing. But for now, the uncertainty is high, our predictions are too harmless, and central banks are being cautious and making mistakes, but not without reason!


Ioannis Tirkides is Economic Research Manager at the Bank of Cyprus and President of the Cyprus Economic Association. Views expressed are personal.An article has also been published in Cyprus Economic Association Blog. Inflation, Wages, and Monetary Policy

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