Despite the extreme and experimental monetary policy and the tight labour markets witnessed over the past decade, price and wage inflation have been far lower than expected. Central bankers have been obsessed by decimal point deviations from the inflation target, all the while underplaying distortions in financial markets, real estate markets and the zombification of corporates. The core of the problem, however, is that price and wage inflation are not generated domestically to the same extent as they once were and cannot, therefore, be quite easily so controlled by domestic monetary policy.
This article is only available to Macro Hive subscribers. Sign-up to receive world-class macro analysis with a daily curated newsletter, podcast, original content from award-winning researchers, cross market strategy, equity insights, trade ideas, crypto flow frameworks, academic paper summaries, explanation and analysis of market-moving events, community investor chat room, and more.
Despite the extreme and experimental monetary policy and the tight labour markets witnessed over the past decade, price and wage inflation have been far lower than expected. Central bankers have been obsessed by decimal point deviations from the inflation target, all the while underplaying distortions in financial markets, real estate markets and the zombification of corporates. The core of the problem, however, is that price and wage inflation are not generated domestically to the same extent as they once were and cannot, therefore, be quite easily so controlled by domestic monetary policy.
Philips Curve is Dead
As an example, let’s look at the relationship between wage growth and unemployment in the US from 1990 onwards. The first chart below depicts quarterly observations of unemployment (on the horizontal axis) and wage growth (on the vertical axis), divided into three periods. The linear trends through these observations have sunk markedly during the last 30 years. In other words, a given unemployment rate is associated with lower and lower wage growth. But the line has also flattened over the decades, meaning that for a given reduction of the unemployment rate, the increase in wage growth has been ever smaller. This is so to such an extent that since 2010 wage growth has remained around 2-3 percent annually, regardless of whether unemployment has been above 8 percent or below 4 percent.
Instead of searching for alternative measures of labour market tightness (the horizontal scale), like the Fed seems to do, we are looking for alternative explanations. It is reasonable to think that some of these include globalisation and digitalisation during the last decades and their effects on the movement of labour, capital, goods and services.
Global, not domestic, labour market matters
In the chart below, the red line shows the share of foreign trade to GDP in the ten largest economies (in PPP terms). Globalisation in this respect has declined since the peak before the financial crisis, mainly as a result of foreign trade playing a lesser role in the Chinese economy. However, this does not reflect the growth of the global labour market following the end of the Cold War, China’s entry into the world markets and the emergence of fast-growing economies like Brazil, India and Indonesia.
Combining the previous measure of trade exposure with each economy’s labour supply, we get a measure that reflects the growth of the global labour market (in blue on the chart below). This measure has shown a stable upward trend, with some exceptions during recessions. The growing global labour market influences domestic wage formation in developed economies in many ways: through labour mobility, cheaper imports and the threat of moving production abroad, as well as through digitalisation, which make trade and price comparisons easier.
Workers of the World, Disunite!
Another striking feature in many countries is the lower labour union affiliation. The trend is the same in low union affiliation countries like the US and in high union affiliation ones. In Sweden, an example of the latter, the share of workers belonging to a union has fallen 15-20 percent from almost 90 percent in the mid-1990s. Whether this is an additional explanation behind the low wage growth, or rather a consequence of it, is a question outside the scope of this article; but, clearly, it adds to the picture of low wage pressure.
Digital Disruption
When it comes down to consumer price inflation, the picture is the same. Globalisation and digitalisation have made global competition tougher. Our other work suggests that factors, such as global labour supply and global growth, have had a larger impact on inflation since the global financial crisis; while traditional factors, such as wages, productivity and inflation expectations, have had a lower or even insignificant relationship with consumer price inflation.
Asset Inflation to Continue
If our conclusion is correct — that domestic monetary policy is unable to affect domestic price and wage formation to any significant extent — we will likely see the same pattern continue. Scared of losing credibility (and, ultimately, independence) if actual inflation deviates as much as a couple of decimal points from the inflation target, monetary policy will get even looser, more experimental and shorter-term. Paradoxically, this has already got the point across in some countries that, the more efforts the central bank puts in to achieve the inflation target with unconventional methods, the less credible professional forecasters perceive it to be.
It is unlikely that any central bank will admit that its tools are not working. That has roughly the same probability (close to zero) that a central bank will forecast a domestic recession. From a central banker’s perspective, both are detrimental to credibility. The consequence will be further distortions in financial markets, real estate markets and the banking and corporate sectors until either there is a reorientation of monetary policy, in order to focus on something other than consumer prices, or a major backlash of globalisation. What we won’t get is any meaningful pickup in price and wage inflation any time soon.
Chart 1: US Quarterly Wage Growth and Unemployment
Source: Bloomberg
Chart 2: Global Labour Supply and Exposure to Foreign Trade
Source: Bloomberg
Jonas Ahlandar is an economist and portfolio manager based in Stockholm, Sweden. His work can be found at Recon Patrol.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)