The link between wage growth and inflation is weakening - this is why

Does higher wage growth fuel inflation? In Europe, that has historically been the case. But the link between wage growth and inflation has weakened in recent years amid low inflation expectations, robust corporate profitability, and strong competitive pressures.

The price of labor—namely wages—is rising at a robust pace, especially in the European Union’s newer member states. Yet, surprisingly, inflation has barely risen. We set out to shed light on this puzzle in Chapter 2 of the Regional Economic Outlook: Europe.

Our Chart of the Week shows that the link between wages and prices in Europe has weakened considerably in the decade since the global financial crisis. More precisely, the impact of wage growth on core inflation has been only two-thirds as strong as in the period before the crisis.

What might account for this shift? Our analysis suggests that several factors are likely at play.

First, firms are more reluctant to raise prices in response to an increase in labor costs when inflation is low and inflation expectations are well anchored. In other words, firms see higher wage costs as temporary, so they limit price increases in the expectation that competitors will do the same.

Second, our analysis suggests that firms’ pricing strategies depend to a significant extent on their exposure to competition, either domestic or from abroad. That explains why sectors, which face more overseas competition, such as manufacturing, are less likely to raise prices in response to higher wage growth than, for example, the services sector.

Finally, corporate profitability is another important factor. We find that the passthrough of wage growth to inflation is significantly lower when corporate profits are healthy. Why? Because profitable firms can absorb a higher wage bill without raising prices, especially if they want to preserve market share.

With inflation expectations near historic lows, rising competitive pressures, and comfortable profit margins, it should not come as a surprise that the link between wage growth and inflation has weakened in Europe. It is also likely that robust wage growth will not meaningfully spur inflation in the near future.

These findings suggest that monetary policy in many European countries should remain accommodative for longer to lift inflation durably to its target. However, policymakers must be on guard for the financial instability that could arise when an extended period of low rates encourages greater risk taking.