Wage Increases in Excess of 6 Per cent, Inflationary Dynamics and Expectations
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This chapter assesses the role played by wage growth in excess of 6 per cent and attempts to establish the effect of excessive wage growth on inflationary dynamics and expectations. Evidence establishes that all categories of inflation expectations rise for nearly 11 quarters (almost three years) in response to a positive excess wage growth shock. The half-life of the inflation expectations shock takes nearly takes seven quarters when considering the influence of two-years-ahead inflation expectations. This is three times the half-life when one-year-ahead inflation expectations are considered.
Furthermore, an unexpected positive inflation expectations shock raises excess wage growth. There is a strong feedback link between inflation outcomes, inflation expectations and excess wage growth. In addition, evidence establishes that inflation expectations shocks induce cyclicality in the wage setting process. Despite inflation expectation declining marginally, both the public and private sector excess wage growth did not decline, suggesting downward rigidities in the labour market limited the adjustment via the aggregate supply to US QE1 shock. This may point to the prevalence of inflation indexed labour contracts that last for multiyear periods, which is normally three years in the case of the public sector. Based on evidence, such cyclicality aspects are pronounced due to the feedback of transitory inflation shocks on wage indexation.
In policy terms, allowing inflation expectation to remain high has the unintended consequences that policy initiatives may not be able to anchor wage growth within the inflation target band. This does not mean it is impossible to achieve sustainable desirable inflation outcomes and well-anchored inflation expectations. This requires policymakers to engage on a persistent drive of “moral suasion” with price setters to discourage the perpetual behavior of wage indexation outside the inflation target band. Furthermore, if the policy objective is to trigger unexpected revision of agents’ decisions regarding future inflation outlook, it is not unusual that certain times necessitate pre-emptive strikes to neutralise inflationary shocks and pressures.
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