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Wages are rising in line with inflation to a limited extent

DNBulletin

Published: 17 August 2022

Etalage Amsterdamse kledingboetiek

There are currently no indications that inflation, through wage increases and a self-reinforcing wage-price spiral, will develop into long-term high inflation. This means there is room for more wage growth in the current macroeconomic conditions. 

Inflation has risen rapidly this year to almost 12% in July. This is a major drain on the purchasing power of most Dutch people.. For employees, the loss of purchasing power can at least partly be compensated by wage increases. Negotiated wage growth is already rising gradually, due to both high inflation and the tight labour market. Companies will pass on some of the rising wage costs in their prices. This interaction mechanism between wages and prices contributes to restoring the macroeconomic balance. However, wage and price increases can also trigger a self-reinforcing spiral, resulting in long-term high inflation and pressure on national income. At present, there are no indications of this happening.

Higher wage growth

The growth of negotiated wages is on the increase, but still lags far behind inflation. After a 2.1% wage increase last year, we estimated wage growth for this year to be 3.2%, primarily due to the very tight labour market. Dutch unemployment is still low and there are staff shortages in several sectors. Wages are also rising due to inflation, which has increased significantly, especially in the last six months. Inflation plays an increasingly important role in wage negotiations, because the real wage – i.e. the wage corrected for higher prices – determines employees’ purchasing power. At present, inflation is mainly due to higher energy prices and production costs for raw materials and transport. Although these prices may remain high for a long time, we expect the steep rise in food and energy prices to subside eventually. This will also reduce inflation, which in turn will have a dampening effect on wage growth.

Wage-price spiral

It is also possible that future wage growth will remain high after inflation has fallen, for example, because collective agreements are usually negotiated for several years, with the agreed wage growth being based on an inflation rate that has since declined. It is also possible that wage negotiations will be affected by expected inflation. In times of high inflation, the expectation may arise that inflation will remain high in the period ahead, which will then be reflected in collective labour agreements. Companies will then be faced with higher costs for longer – though no longer primarily due to higher energy prices, but rather because they have agreed to higher wage increases. They will pass on some of these cost increase in prices, which will give an additional boost to inflation. This will have a further deteriorating effect on the purchasing power of employees, resulting in higher wage demands. A wage-price spiral emerges which triggers a long-term high level of inflation, as wage growth and inflation continue to reinforce each other. Instead of contributing to the restoration of economic equilibrium, high wage increases may then in fact disturb it.

Automatic wage indexation

The risk of a wage-price spiral can be managed by refraining from automatic wage indexation in wage negotiations or collective labour agreements. Automatic wage indexation means that wages are automatically increased by the inflation rate of the preceding six or twelve months, for example. In the 1970s and 1980s, this was a major cause of stagflation – a situation in which long-term high inflation goes hand in hand with unemployment and economic contraction – because wage determination was less flexible due to this automatic indexation. In the event of an unexpected economic downturn in which companies face falling sales, lower real wage levels may help to restore the balance in the labour market. With automatic wage indexation, however, inflation puts a floor under wage growth and wages cannot be easily adjusted to the changed economic conditions. Given the current very low number of collective agreements with automatic wage indexation, the risk of this triggering a wage-price-spiral is still limited.

Room for wage increases

As long as they do not increase fully automatically, there is sufficient macro-economic room to increase negotiated wages. Nominal labour productivity growth could serve as a guideline for determining this room. Differences between sectors must of course be taken into account for a more detailed assessment of the room for wage growth. This room is not the same everywhere; some sectors have been hit relatively hard by the rising cost of commodities, for example. Companies also differ greatly in the extent to which they experience labour shortages, so that higher wage growth may be achieved in sectors with very tight labour markets.

Concluding comments

Higher nominal wage growth contributes to macro-economic equilibrium. It is therefore understandable that employees initially count on higher wages for purchasing power recovery, although this is not possible to the same extent in every sector. However, it is important to ensure that wage increases do not themselves become a driver of long-term high inflation, for example through automatic wage indexation. If prices and wages both continue to rise, purchasing power will also remain unchanged or may even shrink, putting pressure on competitiveness and national income.

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