Dear Director Thomsen,
I welcome the opportunity to discuss on the topic of wage growth and inflation in Europe, which is the main theme in Chapter 2 of the Regional Economic Outlook Europe.
The REO shows that expansionary fiscal policy and looser financial conditions have fueled domestic demand, while wage growth has risen above productivity gains especially in the EU’s New Member States. However, the rapid growth in productivity-adjusted wages has only marginally been transmitted into inflation. After the global financial crisis, the pass-through of nominal wages to inflation has decreased by about three times, from 0.3 to 0.1. Independently from REO, the analysis we undertook at the National Bank of Romania confirms that the pass-through from nominal wages to inflation in recent years was 0.1. One important take-away is that pass-through is time-specific. It is also, country-specific and sector-specific. However, while there are domestic factors at play in each country, we should learn the importance of the regional context – the nominal pass-through in Romania is in line with the one in the other new member states. Monetary policy should also be aligned, and should consider the regional and global context, because any misalignment would imply unwarranted capital flows. Exchange rate policy is also closely linked to this assessment. In fact, according to our calculations, the exchange rate channel is the most efficient transmission mechanism for inflation in Romania, with a pass-through of about 0.3 per year, which is mostly front-loaded. With low worldwide inflation, and with aligned monetary and exchange rate policy, we are importing disinflationary pressures which compensate for the domestic inflationary pressures.
REO provides several cyclical and structural determinants of this slowdown in the link between wages and inflation. I think that there is truth in each of them, yet more research is needed to get to the roots of this fading link. For example, the analysis is based on the cost push theory of inflation; it looks at how price creation reacts, or rather do not react, to increases in wage costs. The alternative view, as the report mentions it, is to look more at the consumption function: even if wages rose faster than productivity, their rise was not enough to recover the loss of welfare that happened after the global crisis.
Another area the flattened Phillips Curve has multiple explanations in the international literature, including the labor market slack, a lower natural rate of unemployment, demographic factors, changes in expectations regarding the real pay growth, the decoupling between growth and inflation, the role of global value chains, technology and market structures. In recent years, it has become increasingly evident that inflationary expectations are better anchored at a lower level. This reduced inflation persistence means that shocks do not have lasting impact on inflation. As former Fed Chair Ben Bernanke said recently at a Brookings conference, increased inflation anchoring has been the most important structural change in monetary policy. Yet, this poses a problem on the reaction function of the monetary policy.
This is not the first time when the Phillips Curve is challenged. It happened before, in the 70s and 80s, when high inflation was complemented by high unemployment. The main line of reasoning at that time was that it was due to the short-term role of supply shocks. In those years, Blanchard and Summers highlighted the hysteresis of unemployment, especially in Europe. Nowadays, the scenario is totally reversed: low inflation is complemented by low unemployment. In some countries, including my country, we are approaching full employment – at least if do not account for the potential return migration. Some economists see the possibility of reverse in an overheating job market.
As mentioned before, price stability, which is the result of better anchored inflation expectations, reduces the sensitivity of inflation to wage growth. This is to say that the monetary policy is the victim of its own success. Yet, even with a weakening wage Phillips curve, other economic laws remain valid. The Balassa- Samuelson model still explains why catching-up economies have a higher inflation than core economies. This is happening in emerging Europe, including in Romania. On the other part, emerging Europe has a lower share of labor cost in value-added than the euro-area and a possible implication is that this lower labor share reduces the efficiency of the Balassa-Samuelson model.
Despite all these, inflation in emerging Europe has been higher than in the euro-area. One explanation is fiscal dominance, which takes place on the background of unfinished structural reforms, incomplete governance structures and insufficiently developed financial markets. While many of the global factors put downward pressures on inflation, fiscal dominance is putting an upward pressure on inflation. Fiscal dominance also creates instability, which drags on consumption; hence people expecting sudden changes in the fiscal stance would have a higher propensity to save.
Another series of explanations presented in Chapter 2 refers to the corporate sector being subject to higher competition (so firms cannot increase prices) and to higher margins of profit (so firms can absorb wage increases). These two explanations are not necessarily contradicting each other, as higher profits can be determined by cheaper intermediate inputs, lower taxation or financing costs, the adoption of new technologies, and so on. However, for emerging Europe, higher profits are probably also linked to the higher share of capital in value-added, and the higher rigidity of wages relative to prices. Several recent studies for Germany, Great Britain and Romania suggest that profit margins are pro-cyclical.
Under these circumstances, the low for long inflation is more than a puzzle and the monetary policy cannot solve it in isolation. It resembles the famous mathematical problem of finding the quadrature of the circle with limited geometric models. One important lesson for us all, as the very recent BIS report on unconventional policy tools shows, is that monetary tools are most effective when used together with a broader set of policies, like fiscal and prudential measures. Monetary policy is not a long-term remedy for structural problems. This leads to my final comment: the accommodative policy today contributes to the build-up of financial vulnerabilities in the years and cycles to come, as our economies become prisoners of the low policy rate trap. Financial stability concerns must be equally important as price stability concerns.
We must acknowledge that practice has moved faster than theory, and that we are forced to react to unprecedented challenges. Therefore, the most important policy tool for a central banker nowadays is the central bank’s credibility itself. In the absence of a standard handbook for the new economic realities, our credibility is crucial for the efficiency of all others policy tools.
19 October 2019, Washington DC