Wages and prices have surged in the past two years, leading to concerns of a wage-price spiral forming. Since wages constitute a substantial portion of firms’ costs, a reasonable hypothesis is that rising wages will result in higher inflation. However, according to the empirical literature, labour cost has little to no impact on inflation and is instead absorbed by firms’ profit margins. Rather, changes in wages lag changes in consumer prices, indicating that inflation influences future wages but not vice versa.
Data in the US and eurozone indicate that wages have not kept pace with inflation since mid-2021, depressing real wages. Unemployment rates have remained low as labour demand has increased while labour supply has been slow to respond. Many commentators fear that tight labour markets will lead to mounting wage pressures and persistently high inflation.
However, businesses’ decisions to raise prices due to changes in labour costs will also consider changes in labour productivity. Unit labour costs (ULCs) adjust wage growth for changes in labour productivity. If productivity increases it will reduce the adverse impact of higher wages on firms’ profit margins and, hence, the pressure to raise prices. Annual changes in headline and core inflation and ULCs in the US and eurozone. In the pre-pandemic period, ULCs appear to lag headline inflation and be insensitive to changes in core inflation. After the pandemic, ULCs seem to have responded strongly to the increases in headline inflation in the US and closely followed the trend in core inflation in the eurozone.
To investigate the empirical relationship between consumer prices and unit labour costs (ULCs) in the US and the eurozone a model is used to illustrate how they respond to shocks. The results are qualitatively similar in the US and the eurozone. The model shows that a one-standard deviation shock to headline inflation has a statistically significant and lasting impact on ULCs in both the US and the eurozone. The response of ULCs increases over time in both areas, but it is much quicker in the US, where it becomes significant one quarter after the shock. In the eurozone, ULCs take more than a year before meaningfully responding to a shock to inflation.
In contrast, for both the US and eurozone, the estimates show that a shock to ULC affects neither headline nor core inflation immediately. In line with the existing literature on the US economy, these results suggest that ULC shocks do not help forecast consumer prices and show that this seems to be the case in the eurozone too. Hence, the concern expressed by some members of the ECB Governing Council about the risk of a wage-price spiral appears excessive.