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Beyond Inflation: Why Wage Growth is “Bad” For Central Banks

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Beyond Inflation: Why Wage Growth is “Bad” For Central Banks
Now that the general theme of central banks has moved towards cutting, some have been able to do so sooner than others. Two of the majors, the Fed and the BOE, are seen as the most hesitant. Analysts suggest they might not get around to cutting until September. The main reason being cited for both is the labor market.

For the Fed, it makes sense that the labor market would be mentioned, because keeping unemployment low is part of its mandate. But that is at odds with the unemployment rate already being below structural level. And the BOE doesn’t have a mandate to care about the employment rate. What gives?

Going Beyond Inflationary Pressure

The simple explanation is that strong wage growth means that people have more money to spend, and that would keep prices up. While that is true, it doesn’t help us understand exactly what central banks are looking for in employment data. And that gets in the way of being able to understand when rates might be cut.

If strong wage growth translated into high inflation, then this leads to the corollary that central banks would be constantly fighting wage growth. But this isn’t true; in fact, wage growth is also good from a monetary policy perspective. It’s a matter of why and how wages are growing. That why and how answers the when of rate cuts, in the current environment.

Answering the Why

We all know that inflation is the result of the law of supply and demand. If demand increases above supply, then prices rise. So, if the amount of money in the economy increases faster than the amount of goods and services, you get inflation. It’s not a matter of wages growing faster than inflation that causes inflationary pressure, strictly speaking. It’s the imbalance between goods and money.

If wages rise faster than production, then consumers have more money to spend but there aren’t enough products and services to meet that demand. That leads to higher prices. Therefore, the issue as far as inflation is concerned, is if wages are rising faster than productivity. If wages are growing slower than productivity, then you have deflation – which is also a problem for central banks.

Applying Corrective Action

Wages growing faster than inflation is a short-hand for wages keeping inflation from coming down to target. But what is driving the underlying inflation issue is too much money chasing too few products and services. Central banks have no control over the latter part of that equation, but they can influence the former, and that’s why they try restrictive monetary policy to reduce the supply of money.

Wages can grow faster than inflation as long as productivity increases at a similar rate. In fact, a simple approximation of how much wages are affecting inflation is to measure wage growth to productivity growth. If that difference is bigger than the central bank’s inflation target, then they are likely to keep monetary policy restrictive – as long as the economy is growing, so they don’t face political pressure to cut.

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