Is this cost-of-living squeeze going to pass?

If workers start demanding better pay we could get a wage-price spiral

The world is divided into two camps on inflation. Those who consider the current price surge “transitory”, a product of higher energy prices and the post-Covid unwind. And those who argue that the current spate of price growth is something longer lasting, something that will usher in a sequence of interest rate hikes.

A key variable in the debate is wages. If wages start rising as workers demand better compensation for the current cost-of-living squeeze, that can create a wage-price spiral, leading to a more prolonged period of price growth.

We certainly have the cost-of-living squeeze with inflation ticking up to a 20-year high of 5.3 per cent in November.

The headline figure masks major price hikes in electricity, gas and other fuels, up 29 per cent up year on year; and petrol and diesel, up 26 and 29 per cent respectively.

Post-Covid labour markets have, however, remained relatively slack, which has helped to keep a lid on wage growth.

While earnings figures for the Irish labour market suggest otherwise, much of that is down to compositional factors: in other words the rise in earnings reflects those remaining in work, who are typically in higher-paying sectors.

The European Central Bank (ECB) president Christine Lagarde and chief economist Philip Lane have stuck to their mantra that inflation is "transitory" and will "fade" next year. The Minister for Finance Paschal Donohoe echoed the sentiment in a Bloomberg TV interview earlier this week.

However, in the US, where the labour market is more flexible and tends to bounce back faster from crises, wage growth tied to pay demands is becoming more apparent.

A recent survey by US think tank and business lobby The Conference Board suggested businesses would bump up pay by an average 3.9 per cent in 2022. That’s the fastest wage growth since 2008.

Higher pay for new recruits was the most commonly cited reason, the result of labour shortages in certain sectors, followed by demand related to inflation and the cost-of-living squeeze .

Transitory

US Federal Reserve chairman Jerome Powell has in recent weeks changed his tune on inflation. He said last week that it was probably time to "retire" the word "transitory" when describing inflation, while suggesting the Fed could accelerate its unwinding of bond purchases that have helped keep longer term borrowing costs low. This is usually viewed as a prelude to rising interest rates, something the ECB has ruled out for 2022 at least.

There is also a school of thought that believes the race-to-the-bottom globalisation that we’ve had for two decades, which has effectively exported price growth, may be at an end as businesses rethink their supply chains and consumers demand greater ESG (environmental, social and governance) standards.

This, they say, will deliver a more durable inflation and a series of interest rate hikes. Our entire financial ecosystem – stock markets, company earnings, government bonds, mortgages – is predicated on low interest rates, and a significant shift in the other direction could have far-reaching consequences. The debate is set to run.