Are we actually in recession and is a wage-price spiral on the cards?

For the majority of textbooks a recession is defined as two consecutive quarters of negative GDP. Whilst a lot of economies might technically go through this objective measure in the next year it is a rather strange economic environment that we live. I don’t recall a recession that coincides with record level unemployment, high consumer spending and a huge number of job openings which in turn has led to wage increases. Recession is usually associated with the opposite – high unemployment, low to nil wage growth and little spending. Therefore the economy isn’t in the usual boom-bust cycle but more of an intentional slowdown. Central banks need to get inflation under control by reducing aggregate demand through higher interest rates. Consumer prices, especially in food and energy, rising faster than wages but with wages rising there is a risk of a wage-price spiral. In order to get the inflation down most central banks only have the tools of interest rates and bank liquidity with both currently in the tightening phase.

New Zealand Employment Data – 3rd August 2022

Today’s figures labour data statistics in New Zealand were interesting to say the least. Although unemployment went up 0.1% to 3.3% against expectations it was wage growth of 7% that really stood out and reflected a really tight labour market almost matching the CPI of 7.3%. This is a major concern for the RBNZ the labour market appears to be the major driver of inflation and the threat of a wage-price spiral is very real. A self-perpetuating inflation cycle could cause domestic inflation in New Zealand to remain high, even if global pressure start to ease. In previous periods of inflation the RBNZ got help in the form of redundancies that forced numbers of consumers to cut their spending. This is unlikely in such labour market conditions and what can be sure is that the OCR will be on the rise again and is likely to increase to 4% by the end of the year.

Theory behind the wage-price spiral

As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve. During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted.

Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.

Each time the government reflates the economy, a period of accelerating inflation will follow a temporary fall in unemployment as workers anticipate a future rise in inflation in their pay demands, and unemployment returns to its natural rate.

The process can be seen in the diagram below – a movement from A to B to C to D to E

Friedman thus concludes that the long-run Phillips Curve (LRPC) is vertical (at the natural rate of unemployment), and the following propositions emerge:

1. At the natural rate of unemployment, the rate of inflation will be constant (but not necessarily zero).

2. The rate of unemployment can only be maintained below its natural rate at the cost of accelerating inflation. (Reflation is doomed to failure).

3. Reduction in the rate of inflation requires deflation in the economy – i.e. unemployment must rise (in the short term at least) above its natural rate.

Some economists go still further, and argue that the natural rate has increased over time and that the LRPC slopes upwards to the right. If inflation is persistently higher in one country that elsewhere, the resulting loss of competitiveness reduces sales and destroys capacity. Hence inflation is seen to be a cause of higher inflation.

Rational expectations theorists deny Friedman’s view that reflation reduces unemployment even in the short-run. Since economic agents on average correctly predicted that the outcome of reflation will be higher inflation, higher money wages have no effect upon employment and the result of relations simply a movement up the LRPC to a higher level of inflation.

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