Avoiding a wage-price spiral requires effort from governments, central banks and social partners

High inflation leads to demands for higher wages

Inflation in the Netherlands reached record levels in September and October 2022. It is uncertain how persistent this period of high inflation will be, with its duration depending to a large extent on price developments in international energy markets. Wage developments are the most important factor from a domestic perspective. Indeed, a major proportion of companies' costs consist of wages. If wages rise significantly, companies will be pressured to raise their prices. At the same time, wage increases are the primary way for workers to offset the inflation-induced loss of purchasing power they are facing. The correlation between inflation and wage growth is a point of extra concern now that prices are rising so rapidly. Could robust wage growth fuel the current unprecedented levels of inflation further? Would this result in a higher risk of a wage-price spiral, in which the interaction between wages and prices goes off the rails and the economy suffers additional damage? And what can societal stakeholders do to help prevent such a derailment?

Wage-price spiral unlikely

The results of the DNB Analysis indicate a low probability of a wage-price spiral at present, also because corporate profit margins are generally healthy and wage growth need not lead to higher prices right away.  Nevertheless, high inflation is currently indeed having an impact on wage formation. It is thus crucial to work to prevent a wage-price spiral, and various societal stakeholders have a role to play. For instance, DNB itself has a responsibility to prevent a spiral through its involvement in the ECB's monetary policy. The ECB pursues an inflation target of 2%, and to avoid a wage-price spiral, it is important to prevent high inflation expectations from persisting for longer. The analysis reveals that recent inflation data is causing longer-term inflation expectations to rise somewhat, which may also prolong wage pressures for longer than desired. For its part, the government can ensure that the measures to compensate households and businesses for higher energy prices are as targeted and temporary as possible, and that the cost of these measures is covered. This will avoid creating additional inflationary pressures due to unnecessary stimulation of the economy.

Finally, parties at collective bargaining tables should remain mindful of the harmful side effects of automatic price compensation on employment and the overall health of the corporate sector. Automatic and full compensation for workers' loss of purchasing power increases the risk of a wage-price spiral.

Starting point for wage growth

There is scope for wage growth on average, however. In companies or industries where this is feasible, a reasonable starting point would be to let wages rise by the sum of labour productivity growth and the growth of the GDP deflator. This would enable the distribution of national income between employers and employees to remain constant. Where companies' profitability and financial health allow, wage growth may exceed this sum. Higher wages may come at the expense of earnings growth, but they will help workers limit their real loss of income. Higher wages are also a logical development in the face of labour shortages.