The extension of the core prediction model to include the effect of real wages

Starting with the current forecast, the CNB's core prediction model has been extended to include a labour market block which describes the inflationary effect of real wage costs. Although the original core prediction model implicitly included real wages, their effect was systematically taken into account only at the level of the short-term forecast, without being directly considered in the modelling of inflation pressures from the real economy by means of the core model. The output gap, which was formerly used for this purpose, is only one part of the theoretical concept of this type of inflation pressures, which reflects the effect of corporations' real marginal costs on the price of production. The extension of the model to include the effect of real wages as another potential source of inflation pressures will thus provide a more structured model-consistent insight into the inflationary effect of the real economy. At the same time, it will be possible to take into account the observed rather anti-cyclical behaviour of real wages in the Czech economy, caused by higher stickiness of nominal wages compared to prices.

The extended model distinguishes two types of inflation pressures from the real economy. The first are rising marginal costs with an increasing volume of production, which correspond to decreasing  returns to production factors and are approximated by the output gap. ¹ The other type of inflation pressures is the effect of real wage costs. If such costs are above their equilibrium level, they have an inflationary effect, and, vice versa, if they are under their equilibrium level, they enable corporations not to increase the price of production. The effect of a deviation of the current level of the average real wage from its equilibrium level, which in the long run rises at the same rate as equilibrium real output (non-accelerating inflation real output), is represented by the real wage gap. The overall inflation pressures from the real economy then correspond to the aggregate effect of the output gap and the real wage gap and are described by the marginal cost gap. The real marginal cost gap and its two components in 2001-2006 are shown in Chart 1.

Chart 1

Real wages in the extended model reflect nominal wages in the business sector and consumer prices adjusted for changes to indirect taxes. The forecasted nominal wage growth is determined by wage growth expectations and the real wage gap. If wages in real terms are below their equilibrium level (a negative real wage gap), households try to increase their level by means of faster nominal wage growth. As a result of the greater stickiness of nominal wages compared to prices, the real wage gap tends to move counter to the cycle in the output gap.

The scheme of the monetary policy transmission mechanism in the extended model is shown below. The central bank sets the level of nominal interest rates, which affect inflation through the direct and indirect transmission channels. The direct channel affects inflation directly through the movements of the nominal exchange rate and import prices and is identical to the original version of the model. The indirect channel, acting through the real economy, is now extended to include the real wage gap. Although the real monetary conditions continue to affect the output gap, the latter now only represents the inflation pressures arising from the volume of production. The other component of real marginal costs, the real wage gap, arises through the combination of nominal wage growth and inflation and constitutes an assessment of inflation pressures with regard to the costs of the production factor of labour.

 
The main difference between the original approach and the new model lies in the latter's more detailed description of inflation pressures from the real economy when producing the forecast. The use of the real marginal cost gap concept enables modelling of the potential contrary effects of the cyclical position of the economy and real wages. At the same time, this richer approach will provide a more intuitive interpretation of inflation pressures in history.

Some other equations have been modified in connection with the extension of the core prediction model described above, for example, the equation describing the formation of inflation expectations. The inflation and rates within the economic cycle and their reactions to various economic shocks in the extended model are, however, very similar to the original version. As in the original version of the model, the output gap remains in the monetary policy reaction function  ² along with the expected deviation of inflation from the inflation target. Chart 2 compares the inflation pressures identified by the original and extended models for the data used when compiling the current forecast. According to the extended model, the anti-inflationary pressures from the real economy subsided more slowly in 2005, in particular.

Chart 2

¹ The estimate of the output gap in the extended model is not fully comparable with that in previous forecasts.
² The monetary policy reaction function was described in the October 2003 Inflation Report.