As U.S. inflation has peaked and edged down slowly, those in Europe are following suit. Yet central banks dare not abruptly stop their tightening despite the highly reliable yield curve inverting deeply (near 100 basis points), showing a strong signal of recession ahead. Even though they know policy takes time to be effective where a stop now would still have a momentum (residual) effect for a few more quarters, they are willing to run a high risk of overdoing it by creating a recession or, more concretely, deepening or worsening it.
The root cause behind this, I guess, is due to the still strong labor market indicators. Unemployment rates are at very or even all-time lows everywhere, and wage growth remains high, albeit below inflation (price growth). This means income growth remains solid, and consumption (or permanent income hypothesis) suggests consumption and GDP growth will not be too bad. This leads to the recall of the wage-price spiral, where one reinforces the other as a vicious cycle. Central banks believe they need to break it down.
The theory behind this spiral is simple: Firms’ output determines prices while their input decides wages. By solving a typical firm’s maximization problem, one can easily arrive at the point that wage is linked to price with a coefficient called a marginal product of labor (MPL). MPL essentially means how much output is produced by utilizing unit labor; it is usually unchanged in the short run (within a few quarters). Thus, the dynamic (time-varying) form of the just-mentioned relationship is wage growth equals inflation.
This is easy to be verified from data. Take the U.S. as an example. Weekly earnings (a better measurement than hourly earnings for those underemployed) growth matches very well with the core CPI inflation (a better measurement than overall, which includes food and energy. non-wage related factors), as the accompanying chart shows. The vertical axes align, suggesting a one-to-one correspondence consistent with the previously mentioned dynamic form. However, wage growth leads to price growth by almost five quarters, as the horizontal axes show.
This suggests a causality from factor input (labor) to output. Although we cannot infer this merely from the time series, it makes sense to say while output demand decides input demand, input prices would be transmitted to output price. But the observed five-quarters lag suggests prices are probably much stickier than expected. Since wage growth has not come down meaningfully even by now, it might be too optimistic to expect inflation to come down quickly. In fact, core inflation, whether measured by CPI or PCE, remains high.
To break down the spiral means to start “working with the labor market” by creating unemployment. In other words, central banks are inevitably worsening the recession ahead. This means “overdone” is already written on the wall. Remember, the first cause of such a spiral is high wage growth—an overheated labor market thanks again to central banks’ easing.
