The methodological framework for evaluating Wage developments relative to inflation

The approach to evaluating the influence of wage developments on inflation is based on the two possible ways in which wages can affect inflation. Wages can simultaneously be potential cost-push and demand-pull inflationary factors. It is not easy to differentiate between wage-cost and wage-demand inflation. This difficulty becomes evident when we try to estimate the contributions of demand-pull and cost-push inflation to overall inflation. 1

Wage-cost inflation due to excess demand
This inflation can be said to occur when the faster wage growth (relative to GDP growth) is due to growth in aggregate demand running into supply-side constraints in the economy. The imbalance on the goods market transfers to the labour market. This shows up in falling unemployment (and/or reciprocally rising employment), with a knock-on effect on the growth in average nominal wage rates. Wages rise faster than GDP chiefly for the following reasons:

  • the number of occupational and regional imbalances on the labour market rises; the newly employed workers also increase the bargaining power of the trade unions; these factors generally lead to a rise in wage rates;
  • the law of diminishing returns to variable inputs applies, i.e. even if average wage rates remain unchanged, the newly employed workers produce less than the average quantity of goods and services but are paid as if they were producing the average quantity, which at constant mark-up pricing must bring about growth in prices of final production.

These additional costs gradually feed through into consumer prices. The rise in prices therefore comes from the costs side, passing from producers to sellers. Each of these is, at its own level, able to absorb and suppress these higher prices for a time out of its mark-up, but sooner or later it must either exit the market (go bankrupt) or let the price pressure pass through into prices for the final consumer. The extent of this pass-through depends on the degree of competition in the relevant segment of the retail market, the price elasticity of demand, the size and duration of the imbalanced wage pressure and on the strength of other non-demand cost factors (prices abroad, exchange rates, etc.). Autonomous wage-cost inflation
We talk of autonomous wage-cost inflation when the excessive wage growth (relative to GDP growth) results from partial breakdowns in the linkage between wages and output, in particular:

  • as a result of unexpected production outages (breakdowns, natural disasters);
  • due to the existence of structural overemployment in certain sectors;
  • when trade unions drive up wages in order to increase the share of wages in GDP with no link to the current demand climate;
  • due to exaggerated inflation expectations.

In a way, this inflation takes the form of an exogenous shock (similar in effect to imported inflation, for example), and is often limited in duration or quickly unwinds. It does not act globally, but locally with limited overspill from sector to sector. That is to say, it does not result from imbalances between output demanded and supplied, and the response to it cannot be based on restricting demand through fiscal and monetary measures implemented by the economic and political authorities.

The basic indicator of possible imbalances on the labour market as an inflation factor is nominal/real unit wage costs. 2 This indicator provides information both at a sector level and at the whole-economy level on whether or not the trend in wages (as part of value added) is reasonable, i.e. in proportion to the trend in value added as a whole. The nature of any inflationary pressures (cost-push, demand-pull, bilateral) ensuing from growth in nominal unit wage costs can be determined by only subsequent analyses of the causes of the changes in this growth.
The change in nominal unit wage costs 3 is calculated as follows:

y-o-y change in nominal unit wage costs = y-o-y change in average nominal wages / y-o-y change in real labour productivity

Growth in nominal unit wage costs means an increase in the nominal wage cost-output ratio resulting from disproportional wage growth relative to productivity growth. The difference between nominal unit wage costs and the inflation indicator indicates either the extent of the absorption of such cost pressures into current prices or the accumulation of these pressures - i.e. a build-up of wage-inflationary potential that might pass through into prices if conditions in the economy ease, for example in a phase of economic recovery. There are three basic scenarios that can arise when comparing nominal unit wage costs with an inflation indicator (such as the GDP deflator) where the change in these indicators has proceeded in the same direction but with different intensity:

  • GDP deflator < nominal unit wage costs
  • GDP deflator > nominal unit wage costs
  • GDP deflator = nominal unit wage costs

However, assessing the effect of wage developments on inflation within these three scenarios also depends on the direction in which the change in nominal unit wage costs and the GDP deflator was proceeding. If, say, in the first scenario, the change in nominal unit wage costs was greater than the change in the GDP deflator amid growth in nominal unit wage costs (nominal unit wage costs > 0), then real unit wage costs increased. In this case, we can then talk of a build-up, via current price developments, of unabsorbed excessive wage growth.

Demand-pull inflation
The second channel through which high demand affects retail prices is its impact on the pricing policy of consumer goods sellers themselves. Here, wages are part of households' current incomes, which co-determine their level of disposable income and final consumption, or in other words their purchasing power on the retail market. In conditions of high demand (during a boom) generated by strong customer purchasing power, and in conditions of weak competition, the final sellers of consumer goods - who are in day-to-day contact with their customers and with the competition in their sector - may feel the need to maximise their revenues and profits by raising prices. Given sufficiently inelastic demand, this may genuinely improve their economic situation. They therefore raise prices "voluntarily" with an eye to higher (than normal) profits without being "forced" to do so by suppliers and by their own cost situation. This can occur even when the economy is running below its potential (for example in a period of weak external demand). This tendency, however, is effectively prevented by competition on the retail market, which (for example when multinational retail chains penetrate the market and redistribution of market shares occurs) can to a large extent block the tendency of traders to put up prices in the absence of significant cost pressures. Competition can thus engender price restraint in sellers and can lead them to maximise their profits through non-price measures.

Analyses of this demand-pull inflationary impulse of wage growth as a factor of aggregate demand are based on examining wages as one of the items of household disposable incomes, which are a key factor of consumer - and therefore also aggregate - demand.

Chart 1

The assessment of the possible effect of household current incomes on inflation is based on evaluating whether the growth rate of consumer demand, or of household consumption, is prompting sellers to raise their prices regardless of their cost or profit situation. The basic scheme of this approach is as follows:

Chart 2

Also taken into account are other circumstances that might, given the current income trend, modify households' propensity to consume, in particular their propensity to save and access to debt financing (additional sources of consumer demand). The elasticity of the demand side of the economy with regard to household incomes is also analysed, as increased demand for imports, and hence a decrease in inflationary pressures, cannot be ruled out either. With regard to the inflation forecast, also important are analyses of the price elasticity of individual household expenditure items, consumer sentiment and expectations of economic developments, own incomes, etc., and, last but not least, the factors modifying the impact of demand on inflation (for example the business and pricing policies of retail chains).

Differentiating between wage-cost inflation due to excess demand and autonomous wage-cost inflation
The basic guide for assessing cost and demand factors is an evaluation of the effect of the input variables (average wages and productivity) on nominal unit wage costs. Other macroeconomic indicators (employment, unemployment, supply and demand in the economy) are also taken into account when assessing the trends in both the numerator and denominator.

For example, the developments in 1999 when the very high growth in nominal unit wage costs was caused inter alia by strong growth in average wages in the business sector (resulting chiefly from the trade unions' inflation expectations) can be identified as a wage-cost shock.

The potential effects of imbalanced wage developments on inflation are also viewed in the wider context of changes in other cost items, since an unfavourable trend in wages per unit of output can be offset by favourable developments in other costs. This can be demonstrated by again using the example of 1999, when the high growth in nominal unit wage costs was offset in businesses' costs - especially in the first half of the year - by favourable imported inflation.

1 In this sense, overall inflation is often likened to a dripstone connecting the floor and ceiling of a cave, where one cannot define where the stalagmite ends and the stalactite begins.
2 Nominal unit wage costs = volume of nominal wages/GDP at constant prices; real unit wage costs = nominal unit wage costs/GDP deflator.
3 In Eurostat statistical practice, the nominal unit labour costs indicator is calculated using "compensation of employees" (which comprises not only wages and salaries, but also employers' contributions to health and social funds) and real GDP.
4 In the Czech economy, wages and salaries make up 42% of households incomes, social incomes 18% and other incomes (employers social contributions, property income, gross mixed income and current transfers) 30%.